| The matching concept is often used
to test whether a particular accounting method clearly
reflects income. However, the IRS’s requirement that one
taxpayer’s revenue match another’s expense may not be upheld by
the courts unless the situation is governed by a specific
statutory or regulatory rule. |
Transactions among corporations that are part of the same consolidated group require the payer and the payee to be treated as one entity.
IRC section 267(a)(2) prevents related taxpayers that use different accounting methods from taking a current deduction on one hand but deferring income recognition on the other. Related taxpayers include corporate controlled groups with a 50% stock ownership requirement.
IRC section 404(d) does not permit any deduction for payments to independent contractors until the year the contractor includes the compensation in income. Compensation to such nonemployees deferred more than 212 months after the close of the payer’s taxable year cannot be deducted until the payee recognizes the income.
An employer that transfers property for services may take a deduction equal to the amount required to be included in the recipient’s income. The service provider must include the fair market value of the property in income in the first year the rights are either transferable by the recipient or not subject to substantial risk of forfeiture.
Section 274(e)(2) now requires an amount match in income in the same period for entertainment expenses for goods, services or facilities provided to officers, directors or 10%-or-greater owners (or parties related to them). But under the Sutherland Lumber-Southwest rule, the company can deduct its actual cost for providing such items to other employees.
Larry Maples, CPA, DBA, is COBAF Professor of Accounting at Tennessee Technological University in Cookeville. His e-mail address is email@example.com . Mark Turner, CPA, DBA, is an associate professor of accounting at Texas State University in San Marcos. His e-mail address is firstname.lastname@example.org .
n most situations, as CPAs know, income must be measured by matching revenue and expenses for the same time period. There are a number of instances, however, in which this general rule does not apply for tax purposes—so many, in fact, that CPAs must pay careful attention to the laws and regulations that govern these situations. In addition, new provisions in the American Jobs Creation Act of 2004 and the Gulf Opportunity Zone Act of 2005 affect the rules in some circumstances.
This article analyzes a number of the instances in which the income/deduction matching concept is broadened for tax purposes. (See “ Income/Deduction Matching Provisions ” for a list of the provisions discussed in the text.)
THE MATCHING PRINCIPLE
The matching concept is often used to test whether a taxpayer’s particular accounting method clearly reflects income. To help protect the tax base, the IRS has broadened tax matching beyond the traditional matching of revenue and expenses to include payer/payee matches. That is, before one taxpayer can record a deduction, another must report a similar amount of income in the same period. Thus income and expenses are matched—but for different taxpayers.
The IRS’s need for special rules is underscored by the fact that the courts have not definitively ruled on requiring payer/payee matches. Thus it is questionable whether the requirement that one taxpayer’s revenue match another’s expense will be upheld unless the situation is governed by a specific statutory or regulatory rule. The rules discussed seem to be conditioned on the degree of the relationship between payers and payees. That is, the closer the relationship the greater is the restriction placed on the payer’s ability to record a deduction.
INTERCOMPANY TRANSACTIONS AND CONSOLIDATED RETURNS
CPAs who deal with corporate clients or employers must be aware that the most restrictive requirements for payer/payee matching involve transactions among companies that are part of the same consolidated group. In these situations, payer and payee are considered part of the same entity.
CPAs need to examine three key components of intercompany transactions to determine their proper treatment: amount, timing and character. Any gains or losses on intercompany asset sales are determined on a separate-entity basis. But because timing is defined on a single-entity basis, gains or losses are deferred until the asset involved leaves the group. The treatment for this purpose also affects the treatment of the property in other respects. For example, if either the seller or buyer is a “dealer” in the property involved in an intercompany transaction, neither can use the installment sale rules to account for the transaction at the time of the sale. A single-entity approach also determines the character of the income or loss. In addition, when either the selling member or the buying member of the consolidated group leaves, the single entity bond is broken and previously deferred intercompany gains and losses can be recognized as other rules now apply.
MATCHING BETWEEN RELATED PARTIES
To ensure taxpayers cannot have their tax cake and eat it too, related parties are required to defer recognition of expenses and interest until they are includible in income. IRC section 267(a)(2) prevents related taxpayers that use different accounting methods from “whipsawing” the government—that is, taking a current deduction on one hand but deferring income recognition on the other. IRC section 267(b) defines related taxpayers to include corporate-controlled groups with a 50% stock ownership requirement (rather than the 80% ownership required for consolidated companies). This lower control requirement, though applicable to more taxpayers, allows for rules that are a bit less restrictive than they are for consolidated entities for purposes of timing expense recognition.
Section 267(a)(2) allows a matching deduction “as of the day” such amount is includible in the payee’s gross income. This language differs from that of other matching provisions discussed below. There is no language in section 267 referring to the year includible, and therefore no ambiguity when the payer and payee have different tax years.
Because section 267 is triggered when payers and payees use different accounting methods, it is important that CPAs consider whether a corporate client will be able to properly claim a deduction when transferring a note to a related payee. The IRS has attempted to force the transferor of a note to wait until the note was paid before taking a deduction. However, in Williams , the Supreme Court allowed taxpayers to take a deduction as long as the negotiable note was includible in the payee’s income. Thus, a taxpayer using the accrual method can deduct a note issued to a related cash-basis taxpayer that would be required to include it in income under the constructive receipt doctrine.
The IRS also had attempted to make taxpayers defer deductions when the payee was a foreign person or entity not required to include the item in income. Congress intervened, adding IRC section 267(a)(3). That section and Treasury regulations section 1.267(a)-3 purposefully avoid the matching rule and allow a deduction for payments to foreign persons when the amount owed is paid.
Planning tip. CPAs should be alert for situations in which amounts owed to a 50%-or-greater shareholder can be deducted. The use of a note can be a simple way to accelerate the deduction.
SECTION 404 DEFERRED COMPENSATION
IRC section 404(d), which relates to nonemployee compensation, does not permit a deduction for payments to independent contractors until the year the contractor includes the compensation in income. Recently, the IRS successfully deferred a taxpayer’s deduction when, arguably, the matching rule was met. This development strengthens the IRS’s ability to defer deductions for payments to independent contractors.
Regulations under IRC section 461(h)(2) include a provision that taxpayers will not be considered to have met the economic performance requirement unless they also meet the timing rule in section 404(d) (Treasury regulations section 1.451-1(a)(2)(iii)(D)). Compensation is considered deferred (and the economic performance requirement thus not met) if payment is made more than 2 1 / 2 months after the close of the payer’s year (temporary regulations section 1.404(b)-1T, Q&A-2).
In Weaver the taxpayer owned 80% of an S corporation and 80% of a C corporation. The S corporation, an accrual-method, calendar-year company, was a wholesaler of construction materials. The C corporation was a cash-method, July 31 fiscal-year window-installing business. On its 1996 return the S corporation deducted $30,000 for management services the C corporation had performed for it that year. The C corporation included the amount in income for its tax year ended July 31, 1997. No part of the fee, however, had been paid exactly one year later, when the S corporation issued an intercompany note to the C corporation for the amount owed. The IRS argued, and the Tax Court agreed, the deduction should be denied under the section 461(h)/section 404(d) timing rule. Since no payment was made within 2 1 / 2 months of the payer’s yearend, no deduction was allowed for 1996—the year the expense otherwise would have been accrued.
Whether payment is made within the cash-method taxpayer’s year that ends within the accrual-method taxpayer’s year is irrelevant under these regulations (according to the Tax Court). The timing of the payment’s deduction is determined with reference only to the accrual payer’s year. If the IRS consistently argues this position, some results at odds with the matching rationale of 404(d) will occur. For example, if both the payer and payee were accrual-method, calendar-year taxpayers, the deduction would be deferred even though the payee had already been taxed on the income.
IRS FLEXIBILITY IN APPLYING SECTION 404
For businesses particularly affected by the section 404(d) timing rule, CPAs can use its accompanying regulations to offer some relief. Under temporary regulations section 1.404(b)-1T, Q&A-2(a), compensation to nonemployees that is deferred more than a brief period of time after the close of the payer’s tax year (limited to 2 1 / 2 months by Q&A-2(b)(1)) cannot be deducted until the payee recognizes the income. Another provision, Q&A-2(b)(2), permits taxpayers to overcome this limitation by demonstrating the impracticability of meeting the 2 1 / 2 month requirement, although such impracticability has to have been unforeseeable at the end of the year.
As an example, revenue procedure 2004-41 outlines circumstances under which an insurance company that encourages health care providers to render quality care in a cost-effective manner through incentive payments will be permitted to include those payments in discounted unpaid losses without regard to section 404. The insurance company bases its incentive payments on data that can be collected only after the end of the taxpayer’s tax year, and payments often are made to providers more than 2 1 / 2 months after yearend. Because applying section 404 and related regulations to the incentive payments would create a substantial administrative burden for both taxpayers and the IRS (and to reduce controversy), the service will not apply section 404 to these payments.
Planning tip. Unless a future court decision overturns or otherwise eases the result in Weaver , it appears the IRS will be successful in enforcing the rule that payment must be made within 2 1 / 2 months of the payer’s yearend. The CPA’s only recourse in attempting to argue for a current deduction may be to try to demonstrate impracticability under the temporary regulations.
PROPERTY FOR SERVICES
IRC section 83(h) allows a deduction for an employer that transfers property for services equal to the amount required to be included in an employee’s or other recipient’s income. While enacted primarily with respect to restricted stock compensation plans, it covers any transaction in which a person (employee or not) receives property for services.
Section 83(a) requires the service provider to include in income the fair market value of the property in the first year the rights either are transferable by the recipient or are not subject to substantial risk of forfeiture. Section 83(h) allows a “deduction under section 162, to the person for whom were performed the services [in] an amount included under subsection (a)....Such deduction shall be allowed for the taxable year in which such amount is included in the gross income of the person who performed such services.”
The IRS has been reluctant to allow deductions under this provision without some assurance tax has been paid on the income. It experimented with a withholding requirement, but relaxed that rule in more recent regulations. CPAs have generally treated the payer and payee separately because there are no relationship criteria in this provision. Therefore, those representing payers have argued they are entitled to a deduction if the income is includible, whether or not they have evidence of actual inclusion.
The IRS won a major victory on this issue in Venture Funding Ltd. Venture acquired the stock of another company as compensation for services in a bankruptcy reorganization and immediately transferred the stock to 12 of its employees (including controlling shareholders and principal officers). Venture claimed a deduction for the fair market value of the stock (more than $1 million), but did not include any of this amount on forms W-2 or 1099 issued to employees, and no employee reported any of the stock as income. The Tax Court denied the deduction when the employees failed to report the income and no W-2s or 1099s were filed.
Planning tip. If the company cannot produce evidence that a 1099 or W-2 was filed on the value of property for services, the CPA should not take a deduction position on the return unless he or she is convinced the income was reported by the service provider.
IRC SECTION 274 EMPLOYEE REIMBURSEMENTS
Payer/payee matching usually requires a match of the amounts involved as well as the time periods. However, for certain taxable fringe benefits, the amounts deducted and the amount included as income may not match. IRC section 274(a) bars the deduction for goods, services and facilities in connection with entertainment unless the taxpayer can prove the expenditure is directly related to or associated with the taxpayer’s trade or business. Section 274(e)(2) provides an exception if these expenses are treated as compensation on the employee’s return.
But what if the cost to provide the facilities exceeds the amount includible in compensation under a formula provided in the regulations? The IRS took the position that the deduction could not exceed the formula income amount, but lost three decisions in the Tax Court, one of which was affirmed by the Eighth Circuit Court of Appeals. This became known as the Sutherland Lumber-Southwest rule: An employer’s deduction for providing an entertainment “perk” to employees is not limited by the compensation reported, but to the entire cost of providing the perk.
However, Congress, in the American Jobs Creation Act of 2004, overturned the Sutherland Lumber-Southwest rule as it applied to “specified individuals”—that is, officers, directors and 10%-or-more owners. The Gulf Opportunity Zone Act of 2005 expanded the ranks of those not eligible to persons related to those specified individuals. For both groups, the deduction the employer can claim is limited to the amount reported as income. But CPAs should be aware that, for other employees, compensation in the form of entertainment still will be subject to the Sutherland Lumber-Southwest rule, and therefore, a deduction by the employer for the full cost (rather than the amount reported as income) may be allowed.
For example, let’s assume a corporation allows an officer to use its airplane for a family vacation. Under the valuation rules, the value of the flight is $2,000, but the cost to the company is $5,000. Unless the corporation can prove the airplane use was directly related to or associated with its trade or business, its deduction is capped at $2,000. However, if the airplane were used by an employee who was not an officer or 10% owner, the Sutherland Lumber-Southwest rule would still apply and the company could deduct the full $5,000.
Planning tip. CPAs should determine whether the use of company assets can legitimately be classified as directly related or associated with the conduct of the trade or business. If not, they should consider whether any of the asset usage was by someone other than a “specified individual,” in which case a full-cost deduction position is proper.
MATCHING NOT ALWAYS REQUIRED
The tax code is not always consistent in requiring payer/payee matching. There is no general statute requiring matching, and many exceptions have been carved out. For example, the code permits an employer to make contributions to pension plans even though there may be no corresponding income recognition for years to come. Many fringe benefits (such as employer-paid health care, child care, and meal and lodging expenses) result in an employer deduction but no income recognition by individual beneficiaries. Still, amounts paid on a taxpayer’s behalf often result in income being realized by a service provider.
In general section 263 requires capitalization of expenditures that create multiperiod benefits. This creates a mismatch in revenue and expense recognition favorable to the government; the payee reports income in the year of sale while the payer spreads the deduction over the asset’s life or upon subsequent disposition of the property. The installment sales rules, if applicable, would reduce or eliminate this mismatch.
Prepaid service revenue generally must be recognized in the year of receipt by both cash and accrual taxpayers. An exception for accrual taxpayers is available if the services are completed before the end of the tax year following receipt of the prepayment. Application of the wherewithal-to-pay concept to prepaid service income ignores any concern for matching, particularly when the amount may not be deductible by the payer (as in the case of many consumer-type prepaid contracts). Prepaid expenses may be deductible, however, under the 12–month rule following recently issued Treasury regulations section 1.263(a)-4(f).
CHECKING THE RULES
As this article has illustrated, CPAs need be concerned about income and deductions matching only when the code or regulations explicitly require it. When a taxpayer’s situation calls for such matching, the practitioner should examine the specific provisions closely; there are nuances that make each provision different.