What Is the Recurring Item Exception for Taxes?
Learn how the recurring item exception allows accrual taxpayers to deduct certain expenses before they are paid, creating a more accurate match of income and costs.
The recurring item exception is a provision within U.S. tax law for businesses that use an accrual method of accounting. This method requires income to be reported when earned and expenses to be deducted when incurred, not necessarily when cash changes hands. The exception allows a business to deduct certain expenses in the tax year they are accrued, even if the final step of economic performance, like payment, has not yet occurred. This rule helps businesses more accurately align their expenses with the revenues those expenses helped to generate within the same accounting period.
Eligibility Requirements for the Exception
To utilize the recurring item exception, both the taxpayer and the specific liability must satisfy four distinct tests. Failing to meet any one of these requirements means the expense cannot be deducted until a later tax year.
The first condition is the “all-events test,” as outlined in Treasury Regulation §1.461. This test is met when all events have occurred that establish the fact of the liability, meaning the business has a fixed obligation to pay. It also requires that the exact amount of this liability can be determined with reasonable accuracy, and an estimate is often sufficient if there is a sound basis for the calculation.
A second requirement involves the timing of “economic performance.” For the exception to apply, economic performance must occur on or before the earlier of two dates: the date the taxpayer files a timely return for the year, including extensions, or the 15th day of the ninth month after the close of that tax year.
The liability must also be recurring in nature. This means the expense is one that can be reasonably expected to be incurred again in subsequent years. A one-time, unusual expense would not qualify under this test.
Finally, the expense must meet either a materiality or a better matching standard. If the item is material, deducting it in the current year must result in a better matching of the expense against the income it relates to. For certain liabilities, such as taxes, this matching requirement is automatically considered satisfied.
Applicable and Excluded Liabilities
Certain types of liabilities commonly qualify for the recurring item exception, provided they meet all the necessary tests. These often include payment liabilities where the final action is remitting funds. Examples include:
- Rebates and refunds owed to customers
- Premiums for insurance policies
- Costs associated with product warranties
- Certain taxes, such as state and local taxes or employer-paid payroll taxes
Some liabilities are specifically excluded from being eligible for the recurring item exception. Interest expense is a prominent example. Liabilities arising from a breach of contract or tort are also ineligible. Furthermore, deferred compensation does not qualify for this exception and is governed by separate rules under Internal Revenue Code Section 404.
Adopting the Exception
A business can adopt the recurring item exception for a specific type of liability in one of two ways. The simplest method is for a taxpayer in the first year they incur an eligible expense. In this situation, the business can adopt the method by simply deducting the expense on its timely filed original federal income tax return.
If a business has already been incurring an expense for which the exception could apply but has not been using it, the adoption process is more formal. The taxpayer must request a change in their accounting method by filing Form 3115, Application for Change in Accounting Method, with the IRS.
Preparing Form 3115 requires calculating a Section 481 adjustment. This adjustment prevents the duplication or omission of an expense amount due to the change in accounting method and is reported on the tax return for the year of the change.
The completed Form 3115 must be filed correctly to be effective. The original form is attached to the taxpayer’s timely filed federal income tax return for the year of the change, while a duplicate copy is filed with the IRS.