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William Brighenti, Certified Public Accountant
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Electing the Ratable Accrual Method to Accrue Real Property Taxes
Pursuant to Internal Revenue Code Section 461: General Rule for Taxable Year of Deduction
by William Brighenti, Certified Public Accountant, Certified QuickBooks ProAdvisor
Accountants CPA Hartford, LLC of Berlin, Connecticut

Accountants CPA Hartford, LLC: William Brighenti, Certified Public AccountantYou have chosen the accrual method as the accounting method on your tax return.  You recognize revenues when earned and expenses when incurred.  Last year you received real property tax bills but did not paid them because of insufficient cash flow.  You deducted the real property taxes on your tax return since you are on the accrual method for tax purposes.  You are subsequently audited by the Internal Revenue Service and denied this deduction.  Why?

According to the Internal Revenue Code Section 461, in order for a liability to have been incurred, allowing the deduction of an expense for Federal income tax purposes, ordinarily several criteria need to be met, two of which are contained in the “all events test” and one in the concept of “economic performance”. 

The all-events test has been met when:
  1. All events have occurred that fix the fact of liability, and
  2. The liability can be determined with reasonable accuracy.
Generally, economic performance occurs for property or services provided when the property or services is provided; for the use of property, economic performance occurs when the property or services is provided or the property is used.  But in regard to tax liabilities, including real property taxes, the Code of Federal Regulations Section 1.461-4(g)(6) clearly specifies that economic performance does not occur until the tax is paid to the governmental authority that imposed the tax:  “Except as otherwise provided in this paragraph (g)(6), if the liability of a taxpayer is to pay a tax, economic performance occurs as the tax is paid to the governmental authority that imposed the tax”, whether or not the taxpayer is on the cash or accrual basis.  Of course, unless there is economic performance during the tax period, there is no deductibility of the expense during that period.

Like many of the tax rules promulgated by the Treasury Department, there is an exception to the requirement of payment of the tax for economic performance to occur in order for its deductibility on one’s tax return:  “certain recurring items”, mentioned in paragraph (g)(6), are treated as incurred during the year and, hence, deductible for Federal income tax purposes.  For an item to be regarded as a recurring item during the year, it needs to possess these following characteristics:
  1. Met the all-events test during the taxable year;
  2. Paid within the shorter of
    1. a reasonable period after the close of the taxable year, or
    2. 8 months after the close of the taxable year;
  3. Recurring in nature and items of such kind consistently treated by the taxpayer as incurred during the taxable year;
  4. Either—
    1. Not material, or
    2. Its accrual results in a more proper match against income than accruing such item in the taxable year in which economic performance occurs.
But, again, like so many of the exceptions to the tax rules promulgated by the Treasury Department, there is usually an exception to the exception to the tax rule:  in this case, the recurring item exception, however, does not apply to liabilities incurred by tax shelters, including those structured as partnerships, where more than 35 percent of the losses during any period are allocable to individuals not actively participating in the partnership.  Since many real estate companies are organized as partnerships for tax purposes, unless the principal partners of these entities are at least actively involved in the partnership, then the partnership may be considered a tax shelter by the Internal Revenue Service and, as a result, ineligible to meet the economic performance requirement, permitted under the recurring item exception.

Referring to a Senate Report issued in 1986, the United States Tax Court made clear in its memorandum decision of the case, Madler v. Commissioner, the meaning of active participation on the part of the taxpayer:

the taxpayer participates, e.g., in the making of management decisions or arranging for others to provide services (such as repairs), in a significant and bona fide sense.  Management decisions that are relevant in this context include approving new tenants, deciding on rental terms, approving capital or repair expenditures, and other similar decisions.                                      
               
For any entity that is not a tax shelter, that entity is permitted to adopt the recurring item exception as part of its method of accounting for any type of item meeting the criteria mentioned above for the first taxable year in which that type of item is incurred, thus allowing it to meet the economic performance requirement and to deduct it on its current year’s tax return.  The election is effected simply by deducting the item in its first year of incurrence.  There is no form required to be filed with the tax return stating overtly its election for the recurring item(s).  The act of doing such in its first year’s occurrence suffices.

Conversely, any partner who receives more than 35% of the profits and losses of the partnership and who does not actively participate in the management of said partnership has characterized that partnership as a tax shelter to the IRS; consequently, that partnership would not be able to accrue real property taxes under the recurring item exception under IRC Sec. 461(h)(3).

For those partnerships and other entities that are construed as tax shelters by the IRS, making them ineligible for the recurring items exception to the recognition of economic performance prior to payment, there is an election available to them to ratably accrue real property taxes.  This method is not surprisingly referred to as the “ratable accrual method” and is briefly described in Section 461(c).

Under this method, the real property taxes are presumed to accrue ratably, or in proportion to the amount of time, over the periods to which they relate.  For instance, if real property taxes relate to years beginning July 1st and ending June 30th, then under the ratable accrual method, if the current tax year is 2010, one-half of the real property taxes for the property tax year ending June 30, 2010, and one-half of the real property taxes for the property tax year ending June 30, 2011 would be deductible to the calendar year taxpayer for the year 2010.

Unlike the recurring item exception method, the ratable accrual method does require a statement of election to be filed along with the taxpayer’s tax return for the first year in which the property tax is incurred, even though consent is not required from the Internal Revenue Service.  In other words, the election is automatic upon filing a statement of election.  The statement needs to include the following information:
  1. The businesses to which the election applies, and the method of accounting used therein;
  2. The period of time to which the taxes are related; and
  3. The computation of the deduction for real property taxes for the first year of the election, or a summary of the computation.
The election to ratably accrue real property taxes, of course, would need to be filed by the due date of the tax return, including any extensions.  Because the election may be made for each separate trade or business, the taxpayer needs to specify will particular businesses to which the election applies.  It will, however, apply to all real property taxes of that trade or business for which the election is made:  the taxpayer is not allowed to ratably accrue some but not all of the real property taxes of the named business or businesses.

The taxpayer is also required here to include its method of accounting for taxes since the election is available to accrual basis taxpayers.

For real property taxes, the period of time to which the taxes relate refers to the tax year of the real property taxes and not that of the taxpayer.   If the real property tax year was July 1st  through June 30th, the taxpayer would indicate the time period for one's fiscal or calendar tax year as follows:  July 1, through June 30.

The computation of the deduction for real property taxes for the first year of the election need not be overly complicated; however, it should tie-in to the amount reported on the tax return.  For instance, assume real property taxes for the real property tax year of July 1, 2009 through June 30, 2010 were $6,000; and assume real property taxes for the real property tax year of July 1, 2010 through June 30, 2011 were $7,000.  A summary schedule as follows would ordinarily suffice on the election statement:

Calendar year ending December 31, 2010:
January 1 through June 30, 2010 (6/12 of $6,000)
$ 3,000
July 1 through December 31, 2010 (6/12 of $7,000)
$ 3,500
Deduction for calendar year ending December 31, 2010
$ 6,500
      
It is advisable to include an appropriate heading to the election statement.  For instance, the heading might read as follows:

Election to Ratably Real Property Taxes
The taxpayer [or partnership] elects under IRC 461(c) to ratably accrue real property taxes.
The following information is provided in accordance with Regulation 1.461-(1)(c)(3)(i).

If the taxpayer wishes to elect this method after the first year of its incurrence, then it would require the consent of the Internal Revenue Service.  The taxpayer would need to file a written request within ninety days after the beginning of the taxable year and would need to include the information mentioned above as well as additional information:
  1. The name and address of the taxpayer;
  2. The businesses to which the election applies, and the method of accounting used therein;
  3. The taxable year to which the election first applies;
  4. The period to which the real property tax relate;
  5. The computation of the deduction for real property taxes for the first year of election (or a summary of such computation); and
  6. An adequate description of the manner in which all real property taxes were deducted in the year prior to the year of election.
The ratable accrual method is not a difficult method for the taxpayer to elect and implement.  However, most taxpayers are unaware of the requirement of electing it for the first applicable tax year of the business, even though consent of the Internal Revenue Service is not required.  Although the recurring items exception would often apply in the absence of its election, if there were any question as to the active participation of a partner in the business, it might be advisable for the taxpayer to elect the ratable accrual method for the recognition of real property taxes anyway.  A number of small partnerships are susceptible to the exposure of being characterized as a tax shelter by the IRS; consequently, it might be prudent for the taxpayer to err on the conservative side and make the ratable accrual election, since failure to do so may result in unnecessary costs to the taxpayer.

This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice.  For further information, please consult appropriate professional advice from your attorney and certified public accountant. 

Have a tax, a QuickBooks, or an accounting question?  Please feel free to submit it under "Comments" on our blog, Accounting, QuickBooks, and Taxes by William Brighenti, Certified Public Accountant, Accountants CPA Hartford, LLC.  For information and assistance on any tax, QuickBooks, or accounting issue, please visit our website:  Accountants CPA Hartford, LLC. Please visit our sister website, Intense Flavors, and see how you can have a gourmet meal on us when we do your accounting, QuickBooks, and taxes.

If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.  The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein.  The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor.

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