Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
INCOME RECOGNITION AND REVENUE RULING 2003-10:
A LARGE SHIP STEERED BY A VERY SMALL RUDDER
Michael Baillif and Monique C. Reid*
*Michael Baillif, Principal, Ernst & Young, LLP, Washington, D.C.; Claremont McKenna College, B.A., 1988; Yale Law School, J.D., 1992; Georgetown University Law Center, LL.M., 1994. Monique Reid, Manager, Ernst & Young, LLP, Washington, D.C.; City University of New York–Queens College, B.A., 1992; William & Mary Marshall-Wythe School of Law, J.D., 2000.
One of the most fundamental issues in tax law involves the timing of when an accrual basis taxpayer recognizes income under section 451. At the heart of this inquiry is a basic question: “What does it mean to have a fixed right to income?” The issue, which appears simple on its face, can be quite difficult in application, given that the answer depends on a myriad of factors, including the taxpayer’s business operations, contractual terms, and commercial practices. Over time, in addressing a wide range of fact patterns, the courts have articulated a variety of principles and established a number of precedents that provide a road map for analysis that most taxpayers find generally workable, albeit not always to their liking.
Unsurprisingly, however, the Service’s traditional view of income recognition has been substantially more expansive than that embraced by both taxpayers and the courts. In recent years, that divergent outlook has manifested itself in terms of the restrictive treatment accorded to taxpayers’ requests to change their accounting methods for recognizing income: these rulings are reviewable only under an abuse of discretion standard and are rarely challenged in the courts. Taxpayers hoped that this rigidity on the part of the Service would be alleviated somewhat through the publication of Revenue Ruling 2003-10. As it turned out, however, that ruling only provided two limited scenarios (clerical errors and same year disputes) that the Service was willing to conclude would not establish a fixed right to income. While in concept such a ruling might have been welcome, the Service’s subsequent interpretation and application of the ruling has been highly problematic. In practice, the Service has adopted the position that, barring one of the exceptions articulated in Revenue Ruling 2003-10, in a close case a taxpayer generally has a fixed right to income. Thus, the much anticipated guidance has failed to lend clarity to a broad range of situations. Instead, it has essentially become the sole touchstone for analysis, a circumstance that, in large part, has caused the Service’s decision making in this area to move with almost Byzantine complexity and, at times, glacial slowness.This Article provides an examination of the well-established income recognition principles that have traditionally governed and should, in the authors’ opinion, continue to govern this area of the law. Further, this Article provides a number of scenarios that present many of the most current and difficult income recognition issues emerging from modern commercial practice, many of which account for the Service’s reluctance to move beyond the four corners of Revenue Ruling 2003-10. In this context, the Article considers ways in which well-established income recognition principles can be applied to such scenarios as a means of resolving them in a manner consistent with equity, administrability, and reasonable tax policy.