On June 7, 1990, the IRS issued a Notice of Proposed Rulemaking on the economic performance requirement of IRC Sec. 461(h). The proposed regulations identify six types of liabilities that must in fact be paid in order for economic performance to be deemed to have occurred.

Definitions of Qualifying Parties

and What Constitutes Payment

The proposed regulations also define to whom the liabilities must be paid and what constitutes payment.

Breach of Contract of Violation of Law. Sec. 1.461-4(g)(2) of the proposed regulations requires liabilities arising out of a breach of contract or violation of law be paid directly to the person to whom they are owed in order for economic performance to have occurred. Sec. 1.461-5(c) of the proposed regulations prohibits the use of the recurring item exception of Sec. 461(h)(3) for liabilities arising out of any worker's compensation act, tort, breach of contract or violation of law. The recurring item exception of Sec. 461(h)(3) requires that in order for an item to be treated as incurred in a taxable year, the all- events test must be met in that year with the exception of economic performance, which must occur by the earlier of 8 1/2 months after the close of the taxable year, or the date the taxpayer files a timely return for that year (for more on the recurring item exception, see Prop. Reg. Sec. 1.461-5). Previously, only those liabilities arising out of a worker's compensation act or tort were expressly prohibited from this exception.

Rebates and Refunds. Pursuant to Sec. 1.461-4(g)(3), rebates and refunds, whether paid in property, money or as a reduction in the price of goods and services to be provided in the future by the taxpayer, will not be considered as having met the economic performance requirement until actually paid by the taxpayer. These rules will apply to all rebates and refunds, payments or transfers in the nature of a rebate or refund whether they are characterized as a deduction from gross income, an adjustment to gross receipts or total sales, or an adjustment or addition to cost of goods sold.

Award, prize, or jackpot. According to Sec. 1.461-4(g)(4), if the liability arises out of an award, prize, or jackpot owed to a particular person, economic performance will not occur until the liability is paid to the person to whom it is owed.

Insurance premiums, warranty, or service contract payments. Pursuant to Sec. 1.461-4(g)(5) of the proposed regulations, premiums in connection with an insurance, warranty, or service contract must be paid to the person to whom they are owed in order for economic performance to occur. The proposed regulations define a warranty or service contract as a contract that a taxpayer would enter into in connection with property that is bought or leased by the taxpayer, and which the other party to the contract would agree to replace or repair under certain circumstances.

Example. Assume "V corporation" is a calendar year accrual method taxpayer that manufactures toys. V enters into a contract with "W," an unrelated insurance company on December 15, 1990. The contract obligates V to pay W a premium of $500,000 before the end of 1993. The contract obligates W to satisfy any liability of V resulting from claims made during 1991 and 1992 against V by any third party for damages attributable to defects in toys manufactured by V. Pursuant to the contract V pays W a premium of $500,000 on September 1, 1993. Assuming the arrangement constitutes insurance, economic performance occurs as the premium is paid. Thus, $500,000 is incurred by V for the 1993 taxable year, even though the terms of the contract benefit V during 1991 and 1992.

Liabilities arising from taxes. The one remaining group of items that will not be deemed as meeting the economic performance test until paid is liabilities arising from taxes Reg. 1.461-4(g)(6). The proposed regulations note that a charge collected by a government agency for specific extraordinary property or services provided to the taxpayer by the government agency is not considered a tax. In regard to taxes, there are certain exceptions to the payment requirement. If a valid election is made under Sec. 461(c) relating to accruing real property taxes, the accrual will be determined under Sec. 461(c). Certain foreign taxes are another exception. If the liability is to pay an income, war profits, or excess profits tax imposed by any foreign country or possession of the U.S. and is creditable under Sec. 901, economic performance will occur when the requirements of the all-events test Reg. Sec. 1.446-1(c)(1)(ii), other than economic performance are met, whether or not the taxpayer elects to credit such taxes under Sec. 901(a).

Any other liability not specifically mentioned. The proposed regulations also provide for payment to occur in order to meet the economic performance test for any liability that is not otherwise addressed in any other section of the proposed regulations Sec. 1.461- 4(g)(7). Because most liabilities involve the provisions of property or services performed by or to the taxpayer (which is discussed in Sec. 1.461-4(d) of the proposed regulations), or are addressed specifically by statute or in other sections of the regulations, this "catch-all" provision will probably not be as all-encompassing as it may appear. It should be noted that any liabilities that fall into this category are expressly prohibited from the recurring item exception of Sec. 461(h)(3) Sec. 1.461-5(c). However, unless otherwise noted in Sec. 1.461-5(c) of the proposed regulations, the liabilities discussed above will be eligible for the recurring item exception as long as they meet the requirements of Sec. 1.461-5 of the proposed regulations.

Payment Must be to the Person

Involved

The proposed regulations require that the specific payment be made actually or constructively to the person involved. Payment must be in such a manner that the recipient would be required to recognize income under the principles of Sec. 451, without regard to Sec. 104(a) or any other provision that specifically excludes an amount from gross income Sec. 1.461-4(g)(ii)(B).

For payment to be considered made, the same definition applying to a cash basis taxpayer that has made a payment will govern. Furnishing the person with a note or other evidence of indebtedness, including a letter of credit or payment to a third party, including a government agency, will not constitute payment to the party involved Sec. 1.461- 4(g)(1)(ii)(A). For example, the purchase of an annuity contract or any other asset for the benefit of a particular person will not constitute payment to that person until ownership of the annuity contract or title of the asset is actually transferred to the person involved.

Effective Date

In general, the effective date of these proposed rules are for liabilities which, under the law in effect before the enactment of Sec. 461(h), would be allowable as a deduction or otherwise incurred in taxable years beginning after December 31, 1989.

However, it should be noted that the effective date of Sec. 461(h) to which these proposed regulations apply was for the period beginning after July 18, 1984. Therefore, taxpayers should not rely on any regulations or rulings that are inconsistent with the general principles of economic performance. Furthermore, Sec. 1.461-4(j)(2) of the proposed regulations states that there will be no Sec. 481(a) adjustment applied to liabilities for which payment constitutes economic performance. For these liabilities, a "cut-off" transition as described in Temp. Regs. 1.461-7T (current Temp. Reg. 1.461-3T would be renumbered as Temp. Reg. 1.461-7T) is permitted.

Regulations are Only Proposed

Although these are proposed regulations, RRA 89 has added proposed regulations to the list of substantial authorities upon which a taxpayer may rely. However, because the above rules are only proposed, they are subject to change. They are, though, a clear indication of the position the IRS will take in regard to certain economic performance issues.