Just Enough: Substantial Performance, Ministerial Acts, and the All Events Tests for Income and Expense Accruals

Abstract

The tax law sets unrealistic expectations for accruing many income and expense items arising out of bilateral contracts. Under an accrual method, a taxpayer generally takes an income item into account when the taxpayer has a fixed right to receive it and takes an expense item into account when the taxpayer has a fixed liability to pay it. The tax law thus expects the taxpayer to determine when all events have occurred to make the right or liability unconditional. The taxpayer might find this determination easy if it were to exchange only one promise for one promise (e.g., seller only promises to perform services and buyer only promises to pay), use words establishing conditional relationships (e.g., the buyer promises to pay if and only if the seller performs the services), and experience nothing short of complete performance (e.g., the seller never provides nonconforming services). But the taxpayer probably doesn’t engage in those transactions very often.
For most transactions, the taxpayer will find it difficult to determine whether all events have occurred to fix rights and liabilities from bilateral contracts. For example, consider a contract that contains a typical explicit requirement that a service provider submit an invoice to a client to receive payment for rendered services. Once the services have been performed, the accrual method rules contemplate that the parties will determine whether the submission of the invoice represents an event that must occur to fix the service provider’s right to income and the client’s liability to pay under the contract. That determination might prove difficult because some authorities and guidance have disregarded requirements to submit documentation whereas others have treated the satisfaction of such requirements as a prerequisite to any finding of fixed rights and liabilities. Aside from raising questions about how to reconcile the authorities and guidance, the differences in treatment highlight a larger issue that tax accounting rules occasionally require, but do not always permit—accruals prior to the full performance of all promises contained in bilateral contracts. As a consequence, taxpayers need to consider whether the occurrence of substantial performance, rather than full performance, represents the last event that must occur to fix rights and liabilities for tax purposes.