CCA 200851086: No guidance on the first materiality test, so GAAP materiality does the work

Plain-English summary

A candid answer to a narrow question about the recurring item exception: the guidance the field wanted does not exist, but a second test in the same regulation gives a workable answer.

The exception matters because of the economic performance rule. An accrual method taxpayer normally cannot deduct a liability until economic performance occurs, which for services or property means waiting until they are actually provided. The recurring item exception relaxes that for liabilities that recur from year to year, letting the deduction be taken in the earlier year if conditions are met. One of those conditions is a choice: the item must be either not material, or its accrual in the earlier year must result in better matching against the related income.

So materiality decides whether the exception is available, and the regulation supplies two separate tests for it. The question put here concerned the first, at section 1.461-5(g)(4)(i), which looks at the amount of the liability both in absolute terms and in relation to other items of income and expense attributable to the same activity. That is an open-textured standard with no threshold in it, and the writer answers plainly: they are not aware of any guidance addressing what is material under it.

Rather than stop there, the reply redirects to the second test, at (g)(4)(ii), which the recipient may already have considered. Under that test a liability is material for recurring item exception purposes if it is material for financial statement purposes under generally accepted accounting principles. That moves the question onto ground the taxpayer has already covered, since a company with audited financials has made materiality judgments there and documented them.

The legislative history quoted in the release, from H.R. Conf. Rep. 98-861, shows how that borrowing works and where it stops. If an item is material for financial statement purposes, it will also be considered material for tax purposes. The example is a calendar-year taxpayer entering a one-year maintenance contract on July 1, 1985. If the expense is prorated between 1985 and 1986 for financial statement purposes, it should be prorated for tax purposes.

Then comes the asymmetry, and it is the reason to read the quotation closely. If the full amount is deducted in 1985 for financial statement purposes because it is not material under generally accepted accounting principles, it may, or may not, be considered an immaterial item for purposes of the exception. Materiality under GAAP carries over to tax. Immateriality under GAAP does not, or at least not automatically. A taxpayer cannot establish that a liability is immaterial for tax purposes simply by pointing to how its auditors treated it, which leaves the open-textured first test still doing work in exactly the cases where a taxpayer most wants a clean answer.

A substantial redacted block follows the quotation, so whatever the writer made of these authorities on the particular facts is not in the release.

This is a clean digital release rather than a scan, so no OCR correction was needed. Kept as released: the regulation cited as "section 1.461-5(g)(4)(i)" rather than as a Treasury regulation; the conference report cited as "H.R. Conf. Rep. 98-861" without a page reference; and the bracketed insertion "[the recurring item]" inside the quotation, which appears in the release.

Ruling snapshot

• Question: What makes a liability material under the recurring item exception's first materiality test?
• Outcome: Advice given. The writer is aware of no guidance addressing materiality under section 1.461-5(g)(4)(i). A separate test in (g)(4)(ii) treats a liability as material if it is material for financial statement purposes under generally accepted accounting principles, and the legislative history provides that an item material for financial statement purposes is also material for tax purposes, while an item immaterial under those principles may or may not be immaterial for purposes of the exception.
• Key authorities: IRC section 461(h)(3); Treas. Reg. section 1.461-5(g)(4)(i) and (g)(4)(ii); H.R. Conf. Rep. 98-861.

Full text (IRS public release)

ID: CCA-941233-08 Number: 200851086
Office: ---------- Release Date: 12/19/2008

UILC: 461.06-01

From: ---------------------
Sent: Thursday, September 04, 2008 12:33 PM
To: ------------------
Cc: ---------------------------------------
Subject: RE: question on recurring item exception

Hi ----------
I am not aware of any guidance addressing what is material under section 1.461-5(g)(4)(i) (consideration of the amount of the liability in absolute terms and in relation to the amount of other items of income and expense attributable to the same activity). However, there is a separate materiality requirement in (g)(4)(ii), which says a liability is material under the recurring item exception if it is material for financial statement purposes under GAAP (you may have already considered this). The legislative history of the recurring item exception provides:

If an item is considered material for financial statement purposes, it will also be considered material for tax purposes. For example, assume that a calendar-year taxpayer enters into a one- year maintenance contract on July 1, 1985. If the amount of the expense is prorated between 1985 and 1986 for financial statement purposes it should be prorated for tax purposes. If, however, the full amount is deducted in 1985 for financial statement purposes because it is not material under generally accepted accounting principles, it may (or may not) be considered an immaterial item for purposes of [the recurring item] exception.

H.R. Conf. Rep. 98-861. ------------------------------------------------------------------------------------------------
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