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.
Constructive Conditions and the All Events Tests
Accrual-method taxpayers generally follow two-pronged all events tests to determine when they should account for income and liability items. One all events test calls for the inclusion of an item in gross income for the first taxable year during which all events have occurred to fix the taxpayer’s right to receive such item and the amount has become determinable with reasonable accuracy. Under a similar all events test, a taxpayer might take a liability into account for the first taxable year during which all events have occurred to fix the fact of the taxpayer’s liability and during which the amount has become determinable with reasonable accuracy.
With these tests as touchstones, taxpayers expect that they need a definite, unconditional right to income or established liability before an accrual can occur. The accrual method simply does not account for items based on their probable happening, no matter how likely. Instead, a taxpayer must satisfy any condition precedent to a right or obligation before accruing the associated income or deduction.
Revenue Ruling 2007-3 could have surprised some taxpayers insofar as it denied a deduction for seemingly unconditional obligations to make payments
under certain contracts. In the Ruling, the Service found that liabilities were not fixed where the payment obligations arose from bilateral contracts that remained executory at year-end. The Ruling explained that the execution of the contracts, without more, was insufficient to establish the fact of liability under the contracts. This conclusion might seem surprising because the facts of the Ruling do not hint that the contracting parties intended to place any conditions on their respective obligations. Consequently, the Service presumably believed that some unidentified aspect of the arrangements prevented all events from occurring to establish the fact of liability.
The Service reached its conclusion by noting that certain events had not occurred by year-end without explaining why the liabilities were conditioned on the occurrence of those events. The Service based its conclusion on a standard it advances for determining fixed liabilities—similar to one it developed for determining fixed rights to income—that basically states a liability becomes fixed upon the earlier of the first occurrence of certain events, including a rendering of performance or the payment becoming due. Revenue Ruling 2007-3 pointedly declared the Service’s position that the mere execution of a contract would not qualify as one of the events that could fix a liability under that standard. But the Ruling stops short of explaining why the Service considers it necessary for certain other events to occur before the fact of liability is established where, as in these situations, the contracting parties do not appear to have intended such results.
Constructive conditions might provide the best explanation for the conclusions in Revenue Ruling 2007-3 as well as the best justification for the standards advanced by the Service. Courts use constructive conditions to establish conditional relationships, which are not evident from agreements, to determine rights and obligations under contracts. As judicial constructs, they subject promised performance to conditions to achieve justice and avoid hardship rather than to reflect the intention of contracting parties. A court could, for example, hold that a promise to pay was constructively conditioned on performance by the other party. If the other party refused to perform, then the constructive condition would achieve justice by excusing the promise to pay in light of the other party’s failure to perform as promised. A constructive condition, therefore, could prevent a taxpayer from having a fixed payment obligation even though the underlying facts and circumstances do not readily reveal the conditional nature of such obligation. The identification of constructive conditions on the obligations to pay thus could enhance the vague explanation from the Service about why the liabilities were not fixed in Revenue Ruling 2007-3.
Courts, however, do not consider every obligation conditional, and constructive conditions could not justify a widespread application of the Service’s standards. Courts construct these conditions only where essential to address concerns about justice and hardship. Constructive conditions become unnecessary where contracting parties address those concerns themselves. For example, parties could specify a desired ordering for performance that inherently establishes an assumed risk that one party could become obligated to pay for services that it might never receive. Individual circumstances thus determine the need for constructive conditions. Unfortunately, the case-by-case approach required to determine the need for constructive conditions does not lend itself to the generally applicable standards advanced by the Service. For instance, the Service applied its standard to find that a taxpayer lacked a fixed liability to pay an insurance premium in Revenue Ruling 2007-3, which appears difficult to support given the lack of either any intention to make the obligation conditional or, as discussed below, any need for a constructive condition in that situation. Instead, the analysis of the insurance premium liability illustrates how a failure to identify conditions precedent—constructive or otherwise—under the Service’s standards leads to unsupportable conclusions.
Revenue Ruling 2007-3 brings into question the appropriate role for constructive conditions in applying the all events tests. Even though taxpayers might attempt to differentiate their circumstances factually from the situations described in Revenue Ruling 2007-3, the Ruling suggests—perhaps inadvertently—that taxpayers need to address at least the potential for constructive conditions in applying the all events tests to every factual situation.
Constructive conditions unfortunately would make the all events tests considerably more difficult to apply, particularly without definitive guidance. But the difficulty is necessary to support findings that taxpayers lack fixed rights to income from or fixed liabilities for facially unconditional contractual obligations. These conditions, however, add little value to the tax system relative to the burden they impose on its administration. It seems preferable, therefore, to disregard constructive conditions in applying the all events tests despite the fact that such disregard could undermine the Service’s rulings on fixed rights and liabilities under its simplified standards, which need to rely on constructive conditions for support.
This Article examines constructive conditions under the all events tests and considers their future in tax accounting. Part II explains the factual situations in Revenue Ruling 2007-3 and how the Service applied its standard to conclude that the taxpayer did not establish the fact of its liability by executing contracts. Part III describes the standards that the Service uses to determine fixed rights to income and fixed liabilities. That description includes discussions about the technical merit for those standards with a particular emphasis on the role and impact of constructive conditions in the context of Revenue Ruling 2007-3. Part IV describes implications for the Service’s standards if the tax system takes constructive conditions into account. In particular, that part questions the effectiveness of those standards in distinguishing between conditional and unconditional obligations for purposes of applying the all events tests. Finally, Part V concludes with reasons why the tax system should disregard constructive conditions in applying the all events tests.
*Assistant Professor of Accounting, University of North Carolina Wilmington. I would like to thank Jack Donovan for sharing his insights and comments about an early draft of this article.