What Is the All Events Test for Tax Deductions?
Understand the tax principle for accrual accounting that governs when an expense is officially incurred and deductible, going beyond just the date on an invoice.
The all events test is a concept in tax accounting for businesses using the accrual method. Unlike the cash method where expenses are recorded when paid, the accrual method recognizes expenses when they are incurred. The all events test determines the specific moment a liability is considered incurred, which allows a business to claim a deduction in the correct tax year.
The First Requirement Fixing the Liability
For a business to deduct an expense under the accrual method, the liability must first be fixed, meaning all events establishing the unconditional obligation to pay have occurred. For example, if a company signs a contract in December for a marketing campaign that runs in January, the liability is not fixed at year-end. The liability is fixed when the campaign is executed in January.
A fixed liability is different from a contingent one, which depends on a future event that may not happen. For instance, with a pending lawsuit, a company may anticipate a payment, but the liability is not fixed until a judgment is entered or a settlement is signed. The legal obligation to pay must be concrete and not dependent on further actions.
An obligation is fixed on the earlier of the date the event establishing it occurs or the date payment is unconditionally due. For example, when a business hires a consultant, the liability becomes fixed as the consultant performs the work. If conditions must be met before payment, such as board approval for employee bonuses, the liability is not fixed until that condition is met.
The Second Requirement Determining the Amount
The second part of the all events test requires that the liability’s amount can be determined with reasonable accuracy. According to Treasury Regulation Section 1.461-1, the exact dollar amount does not need to be known by year-end. A reliable estimate based on available facts is sufficient, which is useful for expenses where final invoices have not been received.
For instance, if a business receives utility services in December but the bill arrives in January, it can estimate the expense based on historical usage and known rates to claim a deduction for that year. If a portion of a liability is certain while another part is contested, the business can deduct the undisputed amount.
The standard of reasonable accuracy cannot be based on speculation. If a service agreement has an hourly rate, but the final number of hours cannot be reliably estimated, the amount cannot be determined. A business must have a sound basis for its calculation, not just vague projections.
The Economic Performance Requirement
In addition to the first two prongs, Internal Revenue Code Section 461 requires that economic performance has occurred. This rule delays the deduction until the underlying activity creating the liability takes place. It was implemented to prevent the acceleration of deductions for expenses to be performed far in the future.
The definition of economic performance depends on the liability. If a liability arises from receiving services or property, economic performance occurs as they are provided. For example, a company that prepays for a year of cleaning services can only deduct the cost monthly as the service is performed. If a taxpayer is obligated to provide services or property, economic performance happens as they are provided.
For certain liabilities, such as those from workers’ compensation or tort claims, economic performance occurs only when payments are made to the claimant. Even if a settlement amount is fixed and determined at year-end, the deduction can only be taken as the payments are sent.
The Recurring Item Exception
An exception to the economic performance rule exists for predictable expenses, known as the recurring item exception. This provision allows a taxpayer to deduct an expense in the year it is incurred, even if economic performance has not yet occurred. The exception is designed to prevent income distortions from routine expenses that span tax years.
To qualify for this exception, several conditions must be met:
- The first two parts of the all events test (fixed liability and determinable amount) are met by year-end.
- The item is recurring in nature and expected to continue.
- Economic performance occurs within 8.5 months after the tax year ends or a reasonable period, whichever is earlier.
- The item is either immaterial, or its deduction in the current year results in a more accurate matching of the expense to the related income.
For example, a business that receives its December telephone bill in January and pays it promptly can use this exception. The expense can be properly deducted in the year the service was used, rather than the year it was paid.