In Revenue Procedure 2015-39 the IRS had provided a safe harbor method of accounting that taxpayers filing on the accrual basis may use to determine economic performance on certain service contracts.

For an accrual basis taxpayer an expense generally can be taken into account when all of the following conditions are established:

• All events have occurred that establish the fact of the liability (the event fixing the liability takes place or payment is due)
• The amount of the liability can be determined with reasonable accuracy and
• Economic performance has occurred with respect to the liability [Reg. §1.461‑1(a)(2)(i)]

Two special rules allow a taxpayer to accelerate the recognition date.  First, if a taxpayer is making a payment to a person providing services to the taxpayer economic performance takes place when payment is made if it is reasonably expected that the services will be provided within 3 ½ months after payment is made.

A second exception exists if the taxpayer makes use of the recurring exception rule found in IRC §461(h)(3)(A) and Reg. 1.461‑5(b).  In that case the expense can be accrued if:

• At the end of the taxable year, all the events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy;
• Economic performance occurs on or before the earlier of
• The date that the taxpayer files a timely return (including extensions) for the taxable year, or
• The 15th day of the ninth calendar month after the close of the taxable year;
• The liability is recurring in nature; and
• Either
• The amount of the liability is not material or
• The accrual of the liability in the taxable year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs

Effective for taxable years ending on or after July 30, 2015 the IRS will now allow a taxpayer to treat services as ratably being provided over the term of a service contract (referred to as a “Ratable Service Contract”) that meets the following requirements:

• The contract provides for similar services to be provided on a regular basis, such as daily, weekly, or monthly;
• Each occurrence of the service provides independent value, such that the benefits of receiving each occurrence of the service is not dependent on the receipt of any previous or subsequent occurrence of the service, and;
• The term of the contract does not exceed 12 months (contract renewal provisions will not be considered in determining whether a contract exceeds 12 months).

If the contract has services that both satisfy and don’t satisfy these requirements, the method can only be used if the contract separately prices the services that do not qualify for this treatment.

A taxpayer using this method only gains economic performance on a ratable basis—the taxpayer must still demonstrate that all events have taken place to establish the fact of the liability and the amount of the liability can be reasonably estimated.  As well, it has to truly be a service that is provided in small portions over time (such as daily janitorial service) rather than simply a single service that takes a long time to complete (the example uses an environmental impact study contract as an example of this type of ineligible service).

A taxpayer that wishes to use this method will need to obtain the IRS’s permission for a change in a method of accounting.  The ruling does add a new automatic change to the list contained in Revenue Procedure 2015-14.  The new change, made by adding section 19.12 to Revenue Procedure 2015-14, is given a designated change number of 220.  Thus a taxpayer who wishes to use this procedure will need to file a Form 3115 with its tax return for the first year it wishes to make use of this method and send a copy of the form to the IRS office in Ogden, Utah listed in the instructions to Form 3115.

The IRS provides the following examples regarding the use of this election.

The first two examples point out generally that the deduction at year end will be limited to the lesser of the amount of the payment due on or before year end or the dollar value of services that are ratably allocated to the proper time period (3 ½ months or 8 ½ months):

Example 1 (Payment Limited Accrual). On December 31, 2015, Taxpayer enters into a one-year service contract with X. Under the contract, X will provide janitorial services on a daily basis to Taxpayer until the end of 2016. Under the contract, Taxpayer pays X $3,000 a month to clean Taxpayer’s offices. The contract requires Taxpayer to pay for each month’s service by the end of the prior month. On December 31, 2015, Taxpayer makes a $3,000 payment to X for the services to be provided in January 2016. Taxpayer reasonably expects X to provide the janitorial services in January. As of December 31, 2015, all events have occurred to establish the fact of Taxpayer’s $3,000 contractually-required payment and the amount of the liability is determinable with reasonable accuracy.

The contract meets the requirements of a Ratable Service Contract in section 4.02 of this revenue procedure because the janitorial services are to be provided on a regular basis (daily); each daily occurrence of the janitorial service provides independent value, such that the benefits from each occurrence of the service are not dependent on the receipt of previous or subsequent janitorial services; and the contract term does not exceed 12 months. Under the provisions of this revenue procedure, Taxpayer may treat economic performance as occurring ratably under the contract. Thus, under the 3 1⁄2 month rule Taxpayer is allowed to incur a liability in 2015 for the $3,000 paid in 2015. For the services provided from February through December 2016, economic performance occurs ratably as the services are provided to Taxpayer each day, and a liability of $33,000 for these services is incurred in 2016.

Example 2 (Economic performance limited deduction). On December 31, 2015, Taxpayer enters into a one-year service contract with X. Under the contract, X will provide landscape maintenance services to Taxpayer from January through December 2016 on a monthly basis. Under the contract Taxpayer pays X $4,000 a month to maintain Taxpayer’s grounds. The contract requires Taxpayer to prepay for the twelve months of services with the full payment of $48,000 due on December 31, 2015. On December 31, 2015, Taxpayer makes the $48,000 payment to X for services to be provided from January 1, 2016, through December 31, 2016. As of December 31, 2015, all events have occurred to establish the fact of Taxpayer’s $48,000 contractually-required payment and the amount of the liability is determinable with reasonable accuracy.

The contract meets the requirements of a Ratable Service Contract in section 4.02 of this revenue procedure because the maintenance services are to be provided on a regular basis (monthly); each occurrence of the maintenance service provides independent value, such that the benefits from each occurrence of the service are not dependent on the receipt of prior or subsequent maintenance services; and the contract term does not exceed 12 months. Under the provisions of this revenue procedure, Taxpayer may treat economic performance as occurring ratably under the contract. Assuming that Taxpayer satisfies the requirements of the recurring item exception, as described in section 2.09 of this revenue procedure, and files its return on September 15, 2016, Taxpayer is allowed to incur a liability in 2015 of $34,000 (8.5 months/12 months x $48,000) for the services provided from January 1 through September 15, 2016. For the services provided from September 16 through December 31, 2016, the period outside of the recurring item exception, economic performance occurs ratably as the services are provided to Taxpayer during that time and a liability for these services of $14,000 (3.5 months/12 months x $48,000) is incurred in 2016.

The next example points out that a service that is truly a single service, not a contract for series of services provided over time, will not qualify for this treatment:

Example 3 (Service provided is not a ratable service). On November 30, 2015, Taxpayer enters into a one-year contract for an environmental impact study with Y. Under the contract, Y must complete and deliver the study by November 30, 2016. In exchange, Taxpayer will pay Y $100,000 when the contract is signed and $400,000 when the study is delivered on November 30, 2016. Taxpayer makes the payments on the specified dates.

Y performs work on the study during 2015 and 2016 and delivers the completed study to Taxpayer on November 30, 2016. On November 30, 2015, all the events have occurred that establish the fact of Taxpayer’s contractually-required payment of $100,000 and the amount of Taxpayer’s liability under the contract can be determined with reasonable accuracy.

The contract does not satisfy the definition of a Ratable Service Contract in section 4.02 of this revenue procedure because the contract does not provide for services to be provided on a regular basis. Rather, the contract specifies that Y will provide to Taxpayer only one service, namely a completed and delivered impact study. Each instance of Y’s work on the study during the contract period does not provide independent value to Taxpayer. Instead, each instance of work on the study is dependent on the previous and subsequent work on the study to achieve its completion. Thus, Taxpayer may not treat economic performance as occurring ratably over the term of the service contract pursuant to the safe harbor in section 4.02 of this revenue procedure and may not rely on the safe harbor to incur a liability for any portion of the $100,000 in 2015. Instead, economic performance occurs when the study is completed and a liability of $500,000 for this service is incurred upon its completion.

Similarly, if a contract provides for a single price but includes both ratable services and those that do not qualify, the contract is not eligible for this treatment.

Example 4 (Combination of qualifying and non-qualifying services for a single price). On December 31, 2015, Taxpayer enters into a one-year service contract with X. Under the contract, X will provide various IT support and maintenance services to Taxpayer, such as providing help desk support to Taxpayer’s employees and maintaining Taxpayer’s existing software and web pages (IT services). The IT services will be provided on a daily basis through December 31, 2016. In addition, under the contract X will create an updated human resources software application for Taxpayer (HR software development service). Under the contract, Taxpayer will pay X a flat fee of $3,000 a month for the IT services and the HR software development service. The contract requires Taxpayer to pay for each month’s services by the end of the prior month. On December 31, 2015, Taxpayer makes a $3,000 payment to X for the IT services and HR software development to be provided in January 2016. Taxpayer reasonably expects X to provide the IT services in January. As of December 31, 2015, all events have occurred to establish the fact of Taxpayer’s $3,000 contractually-required payment and the amount of the liability is determinable with reasonable accuracy.

The contract does not meet the requirements of section 4.02 of this revenue procedure because the contract includes the HR software development service that is not provided on a regular basis. Under the terms of the contract, the HR software development service consists of only one service, an update to Taxpayer’s human resources software application. Each instance of X’s work on updating the software application during the contract period is dependent on the previous and subsequent work to complete the update and does not provide independent value to Taxpayer. Because the contract does not separately price the HR software development service, which does not meet the requirements for a Ratable Service Contract in section 4.02 of this revenue procedure, Taxpayer may not treat economic performance as occurring on a ratable basis over the term of the service contract pursuant to the safe harbor in section 4.02 of this revenue procedure.

However, that problem can be solved if the contract provides separate pricing for the non-qualifying services.

Example 5 (Separate pricing for ineligible services). Same facts as Example 4, except that under the service contract the HR software development service is separately priced at $12,000, with $1,000 of the $3,000 monthly payment allocated to the software development service. The IT services described in the contract meet the requirements for a Ratable Service Contract in section 4.02 of this revenue procedure because the IT services are provided on a regular basis (daily); each daily occurrence of IT service provides independent value, such that the benefits from each occurrence of the service are not dependent on the receipt of prior or subsequent IT services; and the contract term does not exceed 12 months. Under the provisions of this revenue procedure, Taxpayer may treat economic performance for the IT services as occurring ratably under the contract. Taxpayer incurs a liability in 2015 for $2,000 of the $3,000 payment for IT services under the 3 1⁄2 month rule. For the IT services provided from February through December 2016, economic performance occurs ratably as the services are provided to Taxpayer each day and a liability of $22,000 for these services is incurred in 2016. For the HR software development service liability, economic performance occurs when the service is completed and a liability of $12,000 for this service is incurred upon completion.