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Copyright © 2012 Research Institute of America, Inc.FEDERAL TAX ACCOUNTING

*** 2nd Edition 1993, current through 2012 Update ***

Stephen F. Gertzman

CHAPTER 4. ACCRUAL METHODS

Federal Tax Accounting P 4.04

PARAGRAPH: P 4.04 Reporting Items of Expense

TEXT:Section 461(a) provides that the amount of any deduction must be taken in the taxable year that is the proper year

under the taxpayer's method of accounting used in computing taxable income. This requirement precludes the taxpayerfrom accelerating or deferring a deduction beyond the appropriate tax year in order to gain a tax advantage, conform toits financial accounting treatment, or achieve a more precise matching of related items of income and expense. n159

For accrual method taxpayers, there is a three-pronged all events test for determining when the deduction isappropriate. Under this test, a deduction is appropriate in the first year in which three requirements have been satisfied:(1) all events have occurred that fix the fact of liability; (2) the amount of the liability can be determined withreasonable accuracy; and (3) economic performance has occurred. n159.1 Each of these requirements is independent ofthe other. No deduction is permitted until the year by which each has been satisfied. Even then, the deduction is notassured, as the application of the taxpayer's accrual method must clearly reflect income. n159.2 Finally, althoughgenerally applied to the time when expenses may be claimed by an accrual method taxpayer, the three requirements forsatisfaction of the all-events test also apply under Section 1012 in determining when a liability may be accrued, or takeninto account, in determining the tax basis of a capital asset. n159.3

These three requirements are contained in the following Treasury regulation:

Taxpayer using an accrual method.Under an accrual method of accounting, a liability . . . is incurred, and generallytaken into account for Federal income tax purposes, in the taxable year in which all the events have occurred thatestablish the fact of liability, the amount of the liability can be determined with reasonable accuracy, and economicperformance has occurred with respect to the liability. n160

Before 1984, satisfaction of the first two requirements was all that was necessary to permit the accrual anddeduction of the relevant expense. Deduction was proper even though the liability of the taxpayer might consist only ofan obligation to perform services in the future (or to incur further obligations in the future). n161 This construction ofthe test allowed taxpayers to obtain the tax benefit of a deduction before performance or payment was required.

In 1984, Congress became concerned that this construction permitted abuse and created too great a benefit fortaxpayers in light of the time value of money. (See P 11 for discussion of other time value of money concepts.)

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Consequently, Congress enacted an ameliorating provision, generally effective for amounts that otherwise would havebeen allowable as deductions after July 18, 1984. n162 This provision, Section 461(h), added the third requirement fordeduction by providing that the all events test would not be satisfied prior to the time that economic performance occurswith respect to the item at issue. This third requirement was added to the regulations when they become effective onApril 10, 1992. n162.1 These three requirements are discussed in ensuing sections. n163

P 4.04[1] Fact of Liability Must Be Fixed

For an expense to be deductible, all events must have occurred that fix the fact of liability for that expense. n163.1If existence of the liability is subject to any conditions precedent, contingencies, or other circumstances, which preventthe taxpayer from having a recognized, acknowledged, and existing liability, deduction is premature and will be denied.n164 In considering whether a liability is fixed, it is appropriate to determine whether the other party or parties to thetransaction would have a fixed right to receive the amount at issue. n164.1 Determination of the fact of liability must bemade on the basis of facts actually known or reasonably knowable as of the close of the year. n165 The mere fact thatthe entire obligation may not be satisfied by payment is not, by itself, a sufficient basis for denying the deduction.n165.1 Additionally, it is important to note that all relevant facts and circumstances must be taken into account indetermining whether the fact of liability is fixed. Such facts and circumstances include not only the actual agreementsbetween the taxpayer and other relevant parties but also the intent and understanding of the parties with respect to howsuch agreements will be applied. n165.2 Also significant is whether the applicable agreements are clear, definite, andmandatory with respect to the obligations imposed or, instead, are ambiguous, uncertain, and non-obligatory withrespect to such assertedly fixed obligations. n165.3

On the other hand, where a taxpayer is required by Code section or Treasury regulation to take a liability intoaccount before satisfaction of the all-events test, the taxpayer must do so. n165.4 The mere fact that taking suchliabilities into account before they have become fixed is inconsistent with the all-events test does not cause suchregulatory provisions to be invalid, assuming that it was reasonably anticipated that Congress intended such estimatedamounts to be taken into account. n165.5

Similarly, where a Code Section or Treasury Regulation requires that the time for deducting an otherwisedeductible item be deferred, that Code Section must be given effect. For example, Section 461(d) affects the time whenstate taxes may be deducted. It defers the deduction if the traditional time for the taking of the deduction is earlier thanit would have been because of action taken by a state taxing jurisdiction after December 31, 1960. The generallyacknowledged purpose of this Code provision was to prevent states from accelerating the assessment or lien date ofstate taxes from one year to December 31 of the prior year in order to permit state taxpayers to obtain an earlierdeduction of state taxes for federal income tax purposes. n165.6 In Charles Schwab, n165.7 the taxpayer sought toaccrue deductions for California state franchise taxes in an earlier year than the year proposed by the Commissionerbased on the taxpayer's assertion that Section 461(d) was intended to prevent double deductions but was not otherwiseto be applied to prevent a deduction of state taxes in a particular, earlier tax year for federal income tax purposes. Thecourt disagreed, holding that, because of the taxpayer's particular circumstances, which involved an unusual short taxyear and the fact that the taxpayer had been permitted in prior litigation to obtain a tax deduction for the items inquestion, the taxpayer's later tax deductions were nevertheless explicitly covered by Section 461(d). The court held thatthat section applied and that the taxpayer would not be able to prevent its application based on an argument that,without such deduction being permitted, no state tax deduction would be available in a particular tax year for federalincome tax purposes. In other words, while Section 461(d) does prevent double deductions, it does not guarantee adeduction for state taxes in each and every tax year. n165.8

In interpreting this requirement, the courts have tried to strike a balance between the hardship imposed by a literalreading of the requirement and the practical necessity of having a workable test that achieves a clear reflection ofincome. The courts have most often been concerned with (1) identifying the relevant liability; (2) considering whetherrelated items of income and expense will be matched in the same year; and (3) determining whether the liability is inany way contingent or contested. The cases frequently discuss all these points without necessarily focusing on any

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specific point.

As a final matter, the following cases n166 generally focus on whether the fact of the liability has been fixed and,hence, whether a deduction will be permitted. n166.1 While these cases are still relevant for purposes of determiningthe fact of liability, it must be remembered that many predate enactment of the economic performance requirement and,consequently, do not address economic performance. Under present law, a deduction will not be permitted unlesseconomic performance has occurred. This relatively new condition for deduction must not be ignored.

P 4.04[1][a] Identification of Liability

Identifying the relevant liability has often been one of the more difficult issues pertaining to the fact of liability.Taxpayers frequently enter into transactions that obligate them to perform services, transfer property, or take otheraction in the future. To satisfy their initial obligation (the first liability), taxpayers are sometimes required to incurobligations to others in the future (the second liability). For example, if a taxpayer's board of directors agrees to takecertain action that will result in a deductible expense, the issue regarding fixed liability is whether the board's actionitself obligated the company or, instead, merely authorized the company to incur liability at a later time. The question iswhether the first "liability" actually establishes a fixed liability or merely authorizes the taxpayer to incur a liability (asecond liability) in the future. n167

In early cases, the courts often found that the first liability was not fixed (and, therefore, denied the deduction) untilservices were rendered, property was transferred, or second liabilities were incurred in carrying out the obligationsrequired under the first liability. n168 Subsequently, however, courts began finding a fixed obligation at the time of thefirst liability even though the taxpayer had not yet incurred the second liability associated with carrying out theperformance required under the first liability. Many cases involved the obligation of taxpayers to restore or reclaim landused for mining purposes. Deductions were permitted in the year in which the taxpayer's obligation under state or otherapplicable law became fixed, notwithstanding the fact that the taxpayer would not incur liabilities for performance ofthese obligations until later years. n169 Such deductions are permitted only when the taxpayer's obligation is certain.To the extent applicable law or agreements with applicable state authorities are ambiguous and uncertain, therebycausing the obligation of the taxpayer to be speculative rather than fixed, deductions may be denied. n169.1

Similar questions arose in a number of other business contexts. For example, in Gillis v. United States, n170 apartnership bought and sold cotton pursuant to contracts with the Commodity Credit Corporation. Under thesecontracts, the taxpayer was permitted to acquire and sell cotton domestically at a gain only if it agreed to acquire andsell domestic cotton in foreign transactions at a loss. In general, any gain derived from the domestic sale would be offsetby the loss incurred on the subsequent foreign sale. Where the sale resulting in the gain occurred during one taxableyear, the taxpayer reported the gain in the year of the domestic sale and, at that time, estimated and accrued as adeduction the loss that would arise on the foreign sale in a later year. A question arose as to the propriety of thesedeductions. The court held for the taxpayer. "There is no way this export obligation could be viewed as beingcontingent. The transactions in question were designed to be offsetting transactions." n171 The court also relied on thefact that the taxpayer's accounting treatment was "so much in line with plain common sense that [the court is] at a lossto understand what could have prompted the Commissioner to disapprove it." n172

One of the more intriguing issues confronting taxpayers and their advisors concerns when a liability for warrantiesor warranty repairs becomes fixed. In addressing this question, particular attention must be given to the actualobligation of the taxpayer providing the warranty. If the warranty is for defects that arise within a particular period oftime and necessitate specific action by the party to whom the warranty is provided, such as taking the product to aparticular location, handling it in a particular manner, or otherwise complying with non-ministerial requirements, and ifthe obligation of the taxpayer is only to repair or correct the defect, the liability may not be considered fixed at the timeof the sale of the original product to which the warranty relates. n172.1 However, if the liability is to sell property thatis free of defects (the covered defect necessarily existing at the time of sale); obligates the customer to perform onlyministerial acts in order to realize on, or benefit from, the warranty; and allows the taxpayer to satisfy the warranty in

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any of several ways, including, for example, repairing or replacing the defective item or refunding or crediting aspecified amount in payment of damages or for loss in value, it would be difficult to conclude that the warranty liabilitywas not fixed at the time of sale, and a different result may occur. Hence, in any particular situation, whether inevaluating an existing warranty or in drafting new warranty provisions, care and attention should be given to theconsequences of the specific terms of the warranty.

P 4.04[1][a][i] Identification of payee.

As the previous discussion indicates, an obligation may constitute a fixed liability even though the ultimate payee isnot yet identified. n172.2 In Washington Post Co. v. United States, n173 the taxpayer established a deferredcompensation plan for its independent circulation dealers under which it promised to accrue certain amounts on itsbooks each year for the benefit of the dealers. The taxpayer reserved the right to discontinue or alter the plan at any timebut was obligated to distribute all amounts accrued as of the time of discontinuance. However, under the plan, theaccrued amounts did not fully vest in an individual dealer unless and until that dealer either changed his status from thatof independent contractor to an employee of the taxpayer, died, became disabled, or reached age 55. The Commissionerdisallowed deduction of that portion of the amount accrued that was not immediately vested in the individual on thegrounds that the liability was contingent. The Claims Court rejected this contention, observing that the "one overridingreality" in the case was that the taxpayer was "irrevocably bound to pay whatever it accrued to the Fund." n174 Thecourt pointed out that although the ultimate recipients and time of actual payment could not be determined at the time,such uncertainty "does not make the liability any less real, or any less fixed." n175

Similarly, in United States v. Hughes Properties, Inc., n176 the Supreme Court allowed the taxpayer, a gamblingcasino, to accrue and deduct each year the annual increase in amounts shown on its progressive slot machines eventhough the ultimate recipient of such amounts would not be known until a winning combination was pulled. The Courtstated that the identification of the winning player was irrelevant to the existence of the basic liability. n176.1

On the other hand, the inability to identify the persons who will receive the economic benefits at issue may suggestthat there is no fixed liability at all, a circumstance which precludes deduction. For example, in Iowa Southern UtilitiesCo. v. United States, n177 the state regulatory commission permitted the taxpayer utility company to increase its rates(by means of a surcharge) subject to a required reduction in rates to be charged in later years. The increase was intendedto provide funds for the utility to use in meeting various construction financing costs. The utility argued first that thesurcharge was, in fact, a loan, but this argument was rejected by the court. The utility argued next that its obligation toreduce rates in the future amounted to a fixed liability for which it should be able to take an immediate andcorresponding deduction. The court rejected this proposition, noting among other factors that the identities of thepersons to whom the payments would be made were unknown, therefore negating the concept of loan anddemonstrating that the future reductions would be price adjustments only, not fixed liabilities deductible at the time ofthe agreement. The court emphasized the distinction between a deduction from income and a reduction in income. n178

P 4.04[1][a][ii] Likelihood of performance and conditions subsequent.

In some cases, courts have found the likelihood of performance an important practical consideration. For instance,in Helvering v. Russian Finance & Construction Corp., n179 a taxpayer had purchased and mined minerals in theSoviet Union and, as a result, had a contractual liability to pay royalties at a future date. However, pursuant to the termsof the controlling agreement, this liability would be extinguished for certain reasons, e.g., if a strike occurred, if certainparties breached the agreement, or by an agreement of the parties to terminate the contract. The court of appeals heldthat the liability was accruable because the "taxpayer had a reasonable expectance at the time it accrued this liability onits books that its liability would be enforced." n180 The court stated that "the test is whether a taxpayer is justified inentertaining a reasonable expectation that an expense will be incurred." n181 The court went on to say: "When booksare kept on an accrual basis, a presently existing obligation which, in the normal course of events, the taxpayer isjustified in believing he must fulfill, may be accrued. The existence of an absolute liability is necessary; absolutecertainty that it will be discharged is not." n182 The court seemed to base its decision, in part, on the practical

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realization that if an expense or a liability that is attributable to a transaction is not accrued in the same taxable year asthe income from that transaction, the result would be a distortion of the taxpayer's income for both the year in which theincome is accrued and the year in which the expense or liability is actually paid. The court's decision also reflects theprinciple that once a liability has arisen and is fixed, the fact that conditions may later arise and eliminate the liabilitydoes not preclude accrual and deduction. n183

Although this principle is well established, it has not yet been applied to the deduction of interest on convertibledebentures. n184 The typical fact pattern in these cases is that interest on the convertible debentures is paidsemi-annually on dates that do not coincide with the end of the taxpayer's year. The issue is whether the interest thataccrues economically from the last payment date to the end of the taxable year should be allowed as a deduction. Thebond indenture generally provides that if a conversion occurs between interest payment dates, no interest will bepayable for the period from the last payment date through the date of the conversion. The IRS and the courts havedenied the deduction in these cases even though the conversion results in the extinguishment or elimination of apreviously established liability and, in this sense, clearly is a condition subsequent. n185 In light of the SupremeCourt's decision in United States v. Hughes Properties, Inc., n186 it is uncertain whether these decisions will befollowed in the future.

However, in Southwestern Energy Co., n186.1 the tax court followed its decision in Scott Paper. Apparently, noargument was made by the taxpayer as to the impact of Hughes Properties. Although the court stated that its conclusionwas premised on proper application of the all events test and its prior decisions, it remains to be seen how the courtwould distinguish Hughes Properties if required to do so. Arguably, the convertible bond cases are grounded in theoption made available to bondholders to choose interest by not converting or to choose stock (and no interest) byconverting. In such a situation, a court could well conclude that, until the taxpayer has made its choice--either byallowing the interest to be paid at the end of the applicable period or by converting prior to the end of the interestpayment period--there is no fixed obligation. Such an analysis would be reasonable and reconcilable with otherauthorities, but, to date, has not been explicitly set forth.

In addition to the foregoing cases, there may be cases where the "existence of liability is so highly probable that thereasonableness of the expectancy [of that liability] should govern its accrual." n187 For example, in Eastman KodakCo. v. United States, n188 the issue involved the deduction of a liability for payroll taxes on wages accrued in the lastweek of one taxable year. Legal liability for the tax would not actually arise until the succeeding taxable year when thewages were paid. n188.1 Nevertheless, the court stated, "[W]e cannot say . . . that the remote possibility of theplaintiff's bankruptcy injects an element of uncertainty sufficient to deny a deduction. . . . [S]uch reasoning wouldtotally destroy accrual tax accounting. . . . " n189

These cases suggest that the crucial question is whether all operative facts have occurred that establish the liability.The operative facts are those that make it clear that the taxpayer has incurred an obligation to pay money, renderservices, deliver property, or take some other action, which obligation, although not yet fulfilled, is nevertheless fixed.However, it is often difficult to distinguish cases that focus on "reasonable expectancy" from other cases that havedenied the deduction of a seemingly similar expectancy. n190

In contrast, it is relatively easy to distinguish circumstances where the likelihood of payment does not give rise toan immediate deduction, because of the application of other rules. n190.1

P 4.04[1][a][iii] Conditions precedent.

If the existence of the liability is subject to a condition precedent, the obligation is not fixed until the condition hasoccurred or is satisfied. n191 For example, if an obligation does not arise unless demands are made for the rendition ofservices by customers, a deduction prior to the demand will be denied. In Simplified Tax Records, Inc., n192 the TaxCourt denied the deduction for an obligation to render services that did not need to be rendered until demands weremade by customers of the taxpayer. The fact that the demand could be estimated and prudent business would require

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that a reserve be established for it did not justify the deduction. n193

A frequently described rationale for the denial of such deductions is that deductions should not be permitted forliabilities or expenses that might never be incurred. n193.1 However, if an unusual circumstance arises and the taxpayeris able to demonstrate that a purportedly contingent liability could not give rise to a deduction that might not occur, thededuction or liability may be taken into account even though it would not at that time have satisfied all conditionsprecedent. n193.2 On the other hand, if there is a reasonable expectancy that the obligation will be satisfied, theobligation may be considered sufficiently fixed to be deducted. n193.3 Usually, such determinations are made onlywith respect to undisputed amounts that are routinely paid in the ordinary course of business although technicallyunenforceable. n193.4 Although there is considerable merit in the analysis made by the courts in these matters, few, ifany, taxpayers have argued that income should not be accrued in the first instance because of its doubtful collectibility.n194

Another interesting application of the all events test occurred in Spitzer Columbus, Inc. n194.1 In Spitzer, ataxpayer had been charged with unfair trade practices. To resolve the matter, the taxpayer entered into a consent decreewith the state's attorney general pursuant to which the taxpayer agreed to provide certain coupons to customers who hadpurchased new or used vehicles from it during a specified period of time. Upon proper proof to the state, the couponscould be exchanged for cash. Alternatively, the coupons could be used towards payment of any subsequent purchasesfrom, or services rendered by, the taxpayer.

The taxpayer deducted the cash value of the coupons issued (assuming all coupons were exchanged for cash) in theyear in which the consent decree was entered into. The Commissioner sought to deny the deduction until the year (oryears) in which the coupons were redeemed.

The court found in favor of the Commissioner, stating that the consent decree itself did not create any liability. Itmerely provided the former customers to whom the coupons had been issued with an opportunity to use such coupons inthe future. Referring to General Dynamics, n194.2 the court said that the presentation of the coupons in the presentcase was even less of a formality than the filing of claims had been in General Dynamics. A key aspect in each case wasthe fact that, while one might ordinarily assume that such coupons or claims would be submitted in the ordinary course,this is not the case. In General Dynamics, there were significant reasons why such claims would not be filed. Hence,until they were filed, the liability was contingent. In Spitzer, the submission of the coupons to reduce the charges forgoods or services was contingent upon the customer actually deciding it wanted to buy an additional product oradditional services. Also, to exchange the coupons for cash required the submission of certain proof that the customerswere actually entitled to use the coupons. The facts showed that only 634 of 1,057 customers who had applied for cashrebates actually provided the proof required to receive payment. In these circumstances, the court found the filing of theclaims to be more than a mere ministerial act. Although the court did not identify situations in which the filing of aclaim would be a mere ministerial act, intuitively, such circumstances would seem to include situations where there isno reason why someone who could make a claim would not want to do so. n194.3 Nevertheless, the circumstanceshave to be reviewed carefully. Consider, for example, Jeffrey M. Bigler, n194.4 where a taxpayer's invoices tocustomers showed an amount due, a portion of which could be satisfied by the customer returning or providing thetaxpayer with a used part. Although the taxpayer claimed that such a used part was returned or provided in almost 97percent of the cases, the court concluded that the taxpayer had no right to such used part; that the taxpayer failed toprove that the value of a returned used part was substantially below the relevant amount shown on the invoice; and thatas a consequence, the taxpayer had to accrue in income the full amount shown and could not deduct as a liability oroffset against the selling price the assertedly lower value of the used part that was expected to be returned.

P 4.04[1][b] Matching

Under GAAP, costs and expenses are generally required to be deducted in the same period as the revenues to whichthose costs and expenses relate. n195 In many cases, this economic and financial accounting objective of matchingrequires (1) that costs and expenses directly identifiable with particular revenues be deducted in the same period or

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periods in which those revenues are recognized and (2) that other expenses, which relate to particular periods of time, bededucted in or over the periods to which they relate.

Initially, courts adopted a test very similar to that used for financial reporting purposes, i.e., that expenses should bededucted in the same year or years in which related items of income are recognized. For example, the Supreme Courtstated in United States v. Anderson:

[Accrual accounting] enable[s] taxpayers to keep their books and make their returns according to scientificaccounting principles, by charging against income earned during the taxable period, the expenses incurred in andproperly attributable to the process of earning income during that period; and indeed, to require the tax return to bemade on that basis. . . . n196

Similar statements were made by courts in a number of other contexts. For example, in Ohmer Register Co. v.Commissioner, n197 an accrual-basis taxpayer was in the business of selling cash registers and other products. Its salesagents were compensated through commissions on monies received by the company from the sale of its products. Thearrangement provided for "advance commissions" on consummation of a sale and initial payment by the purchaser. Theremainder of the sales commission was also credited to the salesman at that time, pending full payment by the customer.If full payment was not received on the sale, the salesman would lose part or all of his deferred commission. When themerchandise was shipped, the taxpayer reported the full amount of the sale price as income, whether the sale was forcash or on credit. At the same time, it claimed a deduction for the full amount of the salesman's commission. The Boardof Tax Appeals denied the taxpayer's deduction on the ground that, when taken, the liability was "contingent," but thecourt of appeals reversed, holding that denial of the deduction for the accrued commission would distort income, i.e.,the sales income and related sales commission had to be recognized in the same period. n198

In Dravo Corp. v. United States, n199 the court summarized the need for matching by stating:

The question of when items accrue for Federal income tax purposes has been the subject of extensive litigation andmany decisions. From them emerge a series of simple propositions which determine the appropriate period forreflecting items of income and expense. We start with the admonition that in order for tax accrual accounting to providea meaningful picture of operations, the expense items or deductions must be included in the same period as the incomeitems they help to produce. In other words, interrelated items of expense and income must be "matched" in someparticular period. n200

Although these cases might suggest that the matching principle of financial accounting (i.e., that related items ofincome and expense must be recorded in the same taxable year) is a dominant element of accrual tax accounting inorder for income to be reflected clearly, this is not the case. n201 The matching principle is certainly relevant in testingwhether a particular method clearly reflects income for tax purposes, but matching is not of itself the determinative testfor finding a fixed liability or for permitting a deduction. n201.1 Certainty of liability and, since 1984, economicperformance are by far the more dominant concerns. Thus, deduction will generally be denied where an expense is notyet certain (or where economic performance has not occurred) even though the item to be deducted is related to arecognized item of income. n202 With respect to matching, a most salient point was made in Newhouse BroadcastingCorp., n202.1 where the court stated that, where the related items of income and expense meet the tax requirements foraccrual, matching is appropriate and desirable. Stated otherwise, the matching which results from proper application ofthe tax rules is the acceptable, indeed required, matching for federal income tax purposes.

In 1954, Congress attempted to alleviate some of the confusion in the area by enacting Sections 452 and 462, whichwere intended to conform accrual tax accounting to accrual financial accounting in certain instances. However, theseprovisions were repealed retroactively in 1955 because of the Treasury's fear that their application might generate ahuge loss in revenue. As a result of their repeal, confusion continued as to the importance of matching revenues andexpenses through concepts of deferral in income or recognition of expense at a time that might otherwise be inconsistentwith the all events test. n203 Although enactment of the economic performance requirement of the all-events test was

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initially expected to cause matching to be of less significance in the future than it had been in the past, this expectationhas not been realized. Indeed, the confusion as to the importance of matching has continued. n203.1

P 4.04[1][c] Contested Liabilities

The requirement of a fixed liability for the obligation in question prevents a deduction where the liability iscontested by the taxpayer. n204 The term "contest" is defined by the applicable regulations as follows:

A contest arises when there is a bona fide dispute as to the proper evaluation of the law or the facts necessary todetermine the existence or correctness of the amount of an asserted liability. It is not necessary to institute suit in a courtof law in order to contest an asserted liability. An affirmative act denying the validity or accuracy, or both, of anasserted liability to the person who is asserting such liability, such as including a written protest with payment of theasserted liability, is sufficient to commence a contest. Thus, lodging a protest in accordance with local law is sufficientto contest an asserted liability for taxes. It is not necessary that the affirmative act denying the validity or accuracy, orboth, of an asserted liability be in writing if, upon examination of all the facts and circumstances, it can be established tothe satisfaction of the Commissioner that a liability has been asserted and contested. n205

It is apparent from this regulation that determination of whether a contest has occurred cannot be made merely onthe basis of words used to describe an action. Rather, it requires an appraisal of all the facts and circumstances todetermine the true significance of the purported dispute. n206

Since a finding of contest involves a departure from traditional concepts of accrual tax accounting, the concept ofcontest is to be narrowly construed. For example, in Dravo Corp. v. United States, n207 which is often cited and widelyrecognized as one of the leading cases in this area, the court noted a "[c]ongressional intent to restrict the effect of theconcept of "contest" in tax cases."

A finding of contest must be predicated on a genuine, bona fide dispute directed by the taxpayer toward thesubstance of an asserted liability. n208 Such a dispute must be actively and vigorously asserted. Insubstantialquestioning of, or resistance to, a proposed liability will not amount to a contest. n209 On the other hand, it is notnecessary that the dispute be explicit; it may be found from a consideration of all the relevant facts and circumstances.n210 In addition, it is not necessary for the taxpayer itself to wage the dispute; it may be waged on behalf of thetaxpayer. n210.1

Woodmont Terrace, Inc. v. United States, n211 is illustrative of these principles. The taxpayer in Woodmont hadtaken issue with the basis on which a state tax had been computed. Nevertheless, no contest was found. The court heldthat "in the absence of any type of formal proceedings or a more obvious lack of acquiescence, . . . the meeting . . . [todiscuss the deficiencies] did not constitute the type of "contest" contemplated by Dixie Pine Products." n212

Similarly, in Gillis v. United States, n213 a partnership shipped cotton overseas that unavoidably was inferior towhat was called for in the contract. Payments were promptly made on the basis of the contract price and claims weremade for proper adjustment. In accordance with standard practice in the international cotton trade, the contract providedthat these claims could be subjected to arbitration. Because the partnership was able to estimate very closely whatwould eventually be due on these claims, it included in its tax return for the year of sale both the gross receipts and anamount representing anticipated claims of foreign buyers. When the claims were made, several were submitted toarbitration. Because of this, the Commissioner denied the deduction, and his determination was upheld by the districtcourt. However, the court of appeals reversed, pointing out that liability, within a narrow range, was acknowledged andthat "arbitration in the international trade is not as adversative as usual litigation" and should not be viewed "as thehandmaiden of contingency." n214 The court pointed out that it would be unacceptable to penalize the partnership, asurged by the government, for using the arbitration procedure. n215 The court added that the procedure "is not the sameas contesting liability in a judicial proceeding, and we will not treat it as if it were." n216

On the other hand, the nature of the issues being discussed, the amounts of data to be digested in considering such

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issues, and the complexity of the issues may create a dispute (or prevent a liability from being considered fixed) eventhough no formal protest has been made. For example, in Exxon Corp., n216.1 an issue arose over the years in whichinterest on certain federal tax deficiencies would be deducted. The record disclosed that the taxpayer had routinely filedreturns on a timely basis even though it did not have all necessary data available to it at the time the returns were due.As a result, the taxpayer estimated certain amounts and then provided to the agents on audit the necessary adjustmentsto the returns based on the taxpayer's further accumulation, review, and analysis of the relevant facts.

The sheer complexity of what needed to be done to establish the taxpayer's actual tax liability caused the court toconclude that the taxpayer's liability for tax deficiencies and related interest was not sufficiently fixed to allowdeduction of the interest in the years to which the interest related. In so holding, the court noted, among other things,that in order for the liability for the deficiencies to be established, additional information had to be gathered relating tothe tax years at issue; that information had to be organized and analyzed by Exxon and its representatives; negotiationsand discussions had to occur with the tax authorities; any disagreements had to be negotiated and resolved; and all ofthese activities occurred years after the years for which the returns were filed.

This case poses difficult questions for taxpayers. On one hand, the opinion suggests that taxpayers with large,complex businesses may not have the same opportunity as taxpayers with smaller, simpler businesses to review thepositions of agents on audit and then to determine whether to agree with those positions (and get associated interestdeductions in the years to which they relate) or to disagree with or challenge these positions. On the other hand, themere complexity of such a taxpayer's returns, the amount of data to be evaluated, and the nature of the negotiations anddiscussions that often take place with the IRS certainly can suggest that the taxpayer's activities amount to more thaninsubstantial questioning necessary to determine whether to accept a proposed adjustment. In light of this case,taxpayers may be well advised to discuss with the agents on audit whether particular agreed adjustments will beconsidered as uncontested, with appropriate deductions of interest allowed in the years to which the interest relates, orwill be considered as contested. In other words, it may be appropriate to treat the timing of the interest deductions aspart of the matters to be discussed and resolved during the very audit giving rise to the related tax deficiencies.

P 4.04[1][c][i] Payment of contested liability.

As a result of the application of the all events test to contested liabilities, accrual method taxpayers who had, infact, paid the contested liability and were seeking a refund of the amount paid were not treated as favorably as cashmethod taxpayers. Since the liability was in dispute, the deduction would not be permitted for accrual method taxpayerseven though payment had been made. n217

As a consequence, Congress enacted Section 461(f), which permits an accrual method taxpayer to deduct acontested liability if (1) the taxpayer transfers money or other property to provide for the satisfaction of the assertedliability; (2) the contest exists after the time of transfer; and (3) but for the fact of contest, the deduction would havebeen allowed in the year of transfer or in an earlier year. n217.1

The transfer of money or other property that must be made in satisfaction of the asserted liability must be made tothe person asserting the liability or to an escrowee or a trustee. If the transfer is made to an escrowee or trustee, thetransfer must be pursuant to a written agreement among the escrowee or trustee, the taxpayer, and the person who isasserting the liability, and the agreement must provide that the money or other property will be retained (or delivered) inaccordance with the settlement of the contest. n217.2 Alternatively, the transfer may be made pursuant to an order ofthe United States, any state or political subdivision, or any agency or instrumentality of the foregoing. The key point isthat the money or property be transferred beyond the control of the taxpayer. Any transfer that permits the taxpayer tomaintain control over the cash or other property is not a sufficient transfer. n218 However, the particular facts andcircumstances must be evaluated carefully. For example, in Warnock Davies, n218.1 the court found the taxpayer'stransfer of the deed to his residence to be a sufficient transfer even though the taxpayer had negotiated the right toremain in the residence rent free. n218.2

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Assuming other requirements are met, the taxpayer's transfer may be made to an escrow account if there is anagreement among the escrowee, the taxpayer, and the party asserting the liability as to the transfer of funds from escrowat the time the liability is resolved. n219 The courts have made it clear that unilateral transfers (by the taxpayer to anescrow account) that are unknown to the person asserting the liability will not satisfy the regulatory requirement and,hence, a deduction will not be permitted. n220 On the other hand, the regulatory provision does not require that theperson asserting the claim know the amount transferred to the escrow account, only of the account's existence.

An important question is whether the party asserting the claim against the taxpayer must sign the particular trust orescrow agreement. The regulations provide that "in general" a taxpayer may provide for the satisfaction of an assertedliability by transferring money or other property beyond his control "to an escrowee or trustee pursuant to a writtenagreement (among the escrowee or trustee, the taxpayer, and the person who is asserting the liability) . . . ." n220.1 Thecourts have not been consistent in applying this regulation. On one hand, the Court of Appeals for the Second Circuithas held that the claimant must sign the agreement. n220.2 On the other hand, the Eighth and Ninth Circuits have heldthat the signature of the claimant is not required. n220.3 These courts focus on the fact that the words "in general" inthe regulation indicate that the methods of transfer identified in the regulation are illustrative only rather than exclusive.These courts point out that the key factor is whether the money or property is transferred beyond the control of thetaxpayer (i.e., that the taxpayer has relinquished all authority over such money or property). Nevertheless, these courtsalso recognize that the knowledge and assent of the claimant to the transfer may still be relevant to whether the taxpayerhas relinquished control over the property.

In Chernin v. United States, n220.4 the court considered whether a writ of garnishment, which shifted control overcertain funds from the taxpayer to the bank garnishees and thereby prevented the taxpayer from transferring orotherwise exercising control over the funds, had the effect of constituting a transfer sufficient to satisfy the requirementsof Section 461(f). The court held that it did, pointing out that the applicable test was whether the funds were irrevocablyparted with in a manner that was not open to the possibility of tax abuse. In so holding, the court left open thepossibility that the transfer requirement might also be satisfied where the claimant is able to obtain a temporaryrestraining order preventing the taxpayer from controlling the funds at issue.

An interesting question regarding "transfer" arose in Trinity Industries. n220.5 In Trinity, a taxpayer was owedvarious amounts under a variety of contracts. Because of a dispute over the quality of the taxpayer's work with respectto certain contracts arising in tax years before the year at issue, the taxpayer's customers withheld payments due oncertain other contracts arising in the year before the court. The court first held the full amounts due on such later yearcontracts had to be included in income, because the dispute over the earlier year contracts did not prevent accrual of thefull amount due on the later year contracts. The taxpayer then argued that the amounts withheld by its customers shouldbe treated as a "transfer" by the taxpayer with respect to the disputes over the earlier year contracts. Because thewithholding of payments first arose in 2003, the court stated that the first relevant year for raising the question oftransfer was 2003, not 2002, the year then before the court. However, the court also concluded that, even if the correctyears were before the court, the court would not find in favor of the taxpayer. The court explained that the taxpayercould not have a transfer for purposes of Section 461(f), unless the taxpayer at one time had under its control andauthority the money or other property deemed transferred. In this particular case, because the taxpayer never had theamounts that were withheld by its customers within its own control or authority, the taxpayer could not "transfer" thosefunds for purposes of Section 461(f). The court distinguished Chernin v. United States. In Chernin, the writ ofgarnishment issued by the court shifted control from the taxpayer to the bank garnishees. In contrast, the taxpayer inTrinity never had any control that could be shifted or transferred from it.

The economic performance test of Section 461(h) applies to contested liabilities. n221 Thus, an amount transferredto a Section 461(f) trust with respect to a contested liability may not be deducted earlier than when economicperformance occurs. In the case of workers' compensation or tort liabilities, economic performance occurs only aspayments are made to the claimant.

Because payment to a Section 461(f) trust is not a payment to the claimant, many had thought that such a payment

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would not satisfy the economic performance test. However, in Maxus Energy Corp. v. United States, n221.1 the courtnoted that while a taxpayer's payment to a trust might not in all cases discharge the taxpayer's liability to individualclaimants under the trust (and hence would not constitute economic performance), if the payment to the trust doesdischarge the taxpayer's liability, economic performance will be deemed to have occurred.

On November 19, 2003, the IRS and Treasury filed proposed and temporary regulations under Section 461(f) toclarify that the transfer of a taxpayer's note or promise to provide property or services in the future is not a transfer forthe satisfaction of a contested liability under Section 461(f). Moreover, the transfer of a taxpayer's stock or the stock ornote of the related party is not a transfer for satisfaction of a contested liability under Section 461(f). Finally, theproposed and temporary regulations provide that economic performance does not generally occur when a taxpayertransfers money or other property to a trust, an escrow account, or a court in order to provide for the satisfaction of acontested workers compensation, tort, or other payment liability. Instead, economic performance occurs when paymentis made to the claimant. n221.2 These regulations were made effective July 20, 2004. n221.3 Section 461(f) does not,in and of itself, authorize a deduction or determine the character of that deduction. In Chernin v. United States, n221.4an issue arose as to the proper principles to be employed in determining the character of a deduction. The governmentcontended that the character of the deduction at issue should be determined by analyzing the nature of the underlyingliability, which in this case was based on an assertion of embezzlement against the taxpayer by his employer. The courtrejected that contention and instead held that, in accordance with settled principles of tax law, the underlying deductionmust be determined on the basis of what actually happened and not what might have happened. In this case, thetaxpayer was ultimately determined not to have embezzled the disputed funds. Consequently, the taxpayer was entitledto a deduction as a business loss instead of as a non-business loss as asserted by the government. In response to thegovernment's concern that this holding would be unworkable and would require the taxpayer and the IRS to hold taxyears open until a contest is ultimately resolved, the court responded that, if the approach it adapted does, in fact,become unwieldy, the proper forum for redress would be the Congress and not the judiciary.

An important question, as yet not fully addressed, is the treatment of income earned on amounts transferred to anescrow account or a trustee. The Treasury has not yet provided its position on this matter. n222

P 4.04[1][c][ii] Resolution of contest.

Resolution of the contest establishes the fixed liability required under the all events test. The contest is deemedresolved when a final determination has been made by a court and the issue is no longer subject to appeal, or, in othercases, when the relevant party has acknowledged the liability. n223 Determining whether there has been a sufficientacknowledgment of liability to warrant satisfaction of the all-events test is not necessarily subject to a bright line test.For example, in Volvo Cars of North America, Inc. v. United States, n223.1 all circumstances indicated that anagreement had been reached between the taxpayer and the IRS over the amount of interest owed by the taxpayer for acertain period of time. Documents were then prepared for execution by the parties, but these documents were notactually executed until the succeeding year. The issue was whether the liability for the interest was fixed in the earlieryear. The court concluded that it was, stating that, while the agreement for payment of the interest was unenforceablewithout the requisite signatures on the appropriate forms, the lack of a legally binding agreement did not necessarilygovern whether all events had occurred that were necessary to establish liability so that the taxpayer could obtain thededuction. The court then allowed the deduction. On the other hand, a contest is not resolved when a party has enteredinto a settlement agreement but has retained a right to withdraw. In such a case, the liability under the agreement doesnot become fixed until the right to withdraw has expired. n223.2

P 4.04[2] Determination of Amount With Reasonable Accuracy

The requirement that the amount of the liability must be determinable with reasonable accuracy is set forth in theTreasury regulations as follows:

While no liability shall be taken into account before economic performance and all of the events that fix the

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liability have occurred, the fact that the exact amount of the liability cannot be determined does not prevent a taxpayerfrom taking into account that portion of the amount of the liability which can be computed with reasonable accuracywithin the taxable year. n224

The regulations later provide that where a deduction is properly accrued on the basis of a computation made withreasonable accuracy and the exact amount is subsequently determined in a later taxable year, the difference, if any,between such amounts should be taken into account in the later taxable year in which exact determination is made. n225

Once the amount of the liability has been determined, it is that full amount that is subject to accrual. In other words,the amount of the deduction is not limited to the present value of the amount to be paid in the future. n226

As the court made clear in City of New York, n226.1 absent an explicit statutory authorization, the use of presentvalue concepts is appropriate only if necessary to effectuate a clearly stated legislative purpose. In the absence of suchan authorization or clearly stated purpose, the application of such concepts is inappropriate. n226.2

The following questions have been raised in considering whether an amount can be determined with reasonableaccuracy: (1) Must the amount itself be certain? (2) Will the fact that the amount is subject to later adjustment precludeaccrual and deduction? (3) If all facts affecting computation of the amount have not occurred within the taxable year,will the deduction be denied? (4) What additional factors have been found influential in determining whether amountshave been determined with reasonable accuracy? Of course, as with most other aspects of federal income tax, theburden is on the taxpayer to prove the relevant facts for which he contends. n226.3 (5) Would a change in theprocedures used, or the facts evaluated, in determining amounts with reasonable accuracy constitute a change in methodof accounting? n226.4 Finally, because the reasonable accuracy prong of the all-events test for determining whendeductions may be recognized corresponds to the reasonable accuracy prong of the all-events test for determining whenincome is to be recognized, the factors affecting whether amounts have been determined for reasonable accuracy underSection 451 are applicable to whether amounts have been determined with reasonable accuracy under Section 461 andvice versa. n226.5

P 4.04[2][a] Certainty of Amount

The regulation requires only that the amount be determined with reasonable accuracy, not that it be certain. n226.6Thus, if services are rendered to a taxpayer for which the taxpayer is charged $10,000, but the taxpayer admits liabilityfor $6,000 only and contests the remainder, the taxpayer may take into account only the $6,000. n227 The balance maynot be deducted because the amount is contingent and cannot then be ascertained with reasonable accuracy. n228 Infocusing on the need to determine the amount with reasonable accuracy, taxpayers sometimes forget to deduct thatportion of an asserted liability to which they agree. n228.1 Taxpayers inadvertently defer deduction of the entireliability even though only a portion of the liability may be uncertain in amount. Correlatively, examining agents rarelychallenge a deduction in one tax year on the basis that some portion of it should have been accrued and deducted in anearlier year. Of course, while such a position may not be in the government's interest in most cases, situations do arisewhere such a position by the agents will benefit the government.

The rules regarding the determination of an amount with reasonable accuracy and the fact that the amount need notbe certain are fairly clear. Nevertheless, some cases contain language that has suggested a need for certainty. Forexample, the Supreme Court has said that for the expense to be deductible, all events must occur within the year that fixthe "amount" of the taxpayer's liability. n229 It is probable that this language was inadvertent and not intended to alterthe regulatory standard.

As to the precise basis for making computations, the courts have been more liberal than the IRS. "Generally,estimates based on industry-wide experience or the experience of the taxpayer have been accepted by the courts asreasonable." n230 For example, the Ninth Circuit has permitted liabilities to be estimated on an aggregate basis ratherthan on an individual claim basis as had been required in earlier cases. n231

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In ESCO Corp. v. United States, n232 the court considered the impact of actual experience and hindsight on theamounts estimated on the basis of facts and circumstances available to the taxpayer at the end of the year of deduction.The district court found that an average error rate of 10.17 percent was not sufficiently accurate for tax accountingpurposes to permit the deduction. n233 However, the appeals court pointed out that while such hindsight considerationsare important, they are not dispositive. The court held that it was more important that the estimates be based onreasonable, commercially accepted standards. The court added that statistical testing is appropriate for the purpose ofmaking the estimate.

P 4.04[2][b] Possibility of Adjustment

The possibility of later adjustment of the amount does not prevent accrual and deduction. Frequently, theadjustment arises from a condition subsequent, i.e., a fact or circumstance that occurs after the existence of a liabilitythat may terminate or modify the liability itself or cause an adjustment in the amount of the liability. n234 Of course, anadjustment may also arise where the original amount is estimated. n235

P 4.04[2][c] Timing of Facts on Which Amount Is Based

A further question is whether all facts (on which the computation is based) must occur within the year in which thededuction is claimed. The courts and the IRS appear to have somewhat different views of this. Generally, the merewillingness of courts prior to the 1984 Act to permit taxpayers to deduct a liability for obligations associated with futureperformance demonstrates that the amount of the deduction need not be based on facts occurring wholly within the yearof deduction. n236 If this were not the case, deductions would not have been permitted until performance had occurredbecause, until then, it would not have been possible to determine the amount of liability.

Nevertheless, the IRS has indicated in a private letter ruling that the exact amount of the liability must be"determinable by a mere computation based on presently known or knowable factors." n237 The position of the IRS inthe private letter ruling appeared to be that all facts on which the computation is based must occur within the year ofdeduction, although the taxpayer may not learn of them until the subsequent year. If the private letter ruling correctlyreflects the IRS view, it does not appear to be adequately supported. Consider, for example, Bentley Laboratories, Inc.,n237.0a where the court indicated that reasonably anticipated post year-end events could be taken into account indetermining amounts with reasonable accuracy. n237.0b Notwithstanding the foregoing, the burden is on the taxpayerto demonstrate that the amount claimed was determined with reasonable accuracy. n237.1

P 4.04[2][d] Factors Affecting Whether Amount Has Been Determined With Reasonable Accuracy [New]

In evaluating whether amounts have been determined with reasonable accuracy, the courts have weighed a varietyof factors and have expressed relevant standards in various ways. For example, the courts have sometimes suggestedthat the determination of amounts with reasonable accuracy means that such amounts must be based on the bestavailable information. n237.2 Of course, determining whether information is "available" and which information is the"best" may be problematic. Moreover, it is clear that use of the best information available does not require a taxpayer touse procedures or to take actions or make evaluations that would be prohibitively expensive or overly burdensome.n237.3

The expertise of the persons making the determinations is also relevant. For example, in Harrold v. Commissioner,n237.4 the court held that the taxpayer's determination was acceptable, noting that the taxpayer had many years ofexperience on which such judgments could be based. Similarly in Denise Coal Co., n237.5 the court held that thetaxpayer had shown that its estimates had been made by experts, who were knowledgeable in the field and had takeninto account all relevant facts and circumstances. The experts included the taxpayer's own engineers as well as outsidecontractors. To the extent that the taxpayer does not rely on such experts, but instead relies on mere, unsupported rulesof thumb, the taxpayer's determination may not be allowed. n237.6 In this same vein, the particular relevant experienceneed not be limited to the actual experience of the particular taxpayer. For example, determinations based on

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industry-wide experience have also been considered appropriate. n237.7

Although frequently relevant, the use of hindsight data to confirm the reasonableness of the prior determinations isnot nearly as significant as whether the initial determinations were based on a proper consideration of all relevant factsand circumstances. This seems to be the case whether the difference between the initially determined amounts and thelater determined actual amounts is material or insignificant. n237.8 Nevertheless, as indicated above, hindsight datamay well be relevant. For example, in Spitzer Columbus, Inc., n237.9 the issue involved the deductibility of amountsowed by the taxpayer as a result of having issued certain valuable coupons to former customers. In determining that theissuance of the coupons did not create a fixed liability, the court pointed out that a substantial portion of the couponswere subsequently found not to create any liability in the taxpayer. While the court did not focus on this particular factin finding that a reasonable amount had not been determined, it seems as though the court could have done so.

An interesting case in this area involved a taxpayer who sought to induce prospective purchasers to buy its goodsby issuing warrants to them to buy the seller's stock, the warrants to become exercisable only after certain conditionswere met. n237.10 The court held that the difference between the value of the seller's stock at the time the warrantswere issued and the value of the stock at the time the warrants became exercisable represented the equivalent of a salesdiscount or sales allowance which would be taken into account by the taxpayer in the year in which the warrants wereexercised. Although the court found that the seller's liability associated with the issuance of the warrants became fixedwhen the warrants were exercisable, the deduction for this sales discount or allowance was not considered determinedwith reasonable accuracy until the warrants were actually exercised. In this regard, the court focused on the fact that thevalue with which it was concerned was the actual cost to the seller of issuing the stock upon the exercise of the warrantsand, hence, this value could only be determined at the date of exercise.

P 4.04[2][e] Change in Manner of Determining Amounts With Reasonable Accuracy [New]

Over time, new or additional facts may be considered by taxpayers in determining amounts with reasonableaccuracy; new procedures may be followed; new technology may be employed; and new judgments may be made. Aquestion that sometimes arises is whether a change by the taxpayer in its process for--or facts consideredin--determining amounts with reasonable accuracy constitutes a change in method of accounting. Generally, the answeris that such a change is not a change in method of accounting. Otherwise, taxpayers would be required to ignorepotential improvements in the accuracy of its estimates unless prior IRS approval were obtained. The determination ofamounts with reasonable accuracy is generally a question of fact to be taken into account based on all relevant facts andcircumstances. The manner in which such determinations are often made is less significant than whether the amountsthemselves have been determined with reasonable accuracy, under whatever procedures are employed. For example, inESCO Corp. v. United States, n237.11 the taxpayer changed its procedure for determining amounts with reasonableaccuracy by using more sophisticated statistical data and forecasting methodologies, which more accurately predictedthe amounts of the expenses in question. The court concluded that such a change was a change in underlying facts andnot a change in method of accounting. The court noted that the taxpayer's method of accounting was an accrual method,an element of which was determination of amounts with reasonable accuracy. The use of more sophisticated means toobtain more accurate estimates should not, in the court's view, be regarded as a change in method of accounting forwhich prior approval of the Commissioner is required.

P 4.04[3] Economic Performance

For several years prior to 1984, the trend of court decisions was to permit deductions for liabilities to perform (or toincur expenses in connection with performing) obligations in the future. This, combined with opportunities forestimating the amounts of the liabilities in question, was perceived by the Treasury as leading to abuse. In many cases,taxpayers were able to obtain large deductions and then use the tax savings arising from the deductions to fund paymentof the liability itself. For example, in the case of the so-called structured settlement, a taxpayer with a tort obligationmight settle with the plaintiff by agreeing to pay some amount in the future. The taxpayer would obtain a presentdeduction that, in turn, would create tax savings that could be invested. The tax savings plus the after-tax earnings from

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investment of these savings provided the amount necessary to pay the plaintiff. In such a case, the government bears theeconomic cost of paying the taxpayer's obligation. In general, this was part of the so-called time value of moneyproblem, i.e., permitting present deductions without taking into account the time delay in the payment of the amounts atissue. n238

Congress believed that these opportunities necessitated a change in the rules governing application of accrualmethod reporting to deductions. n238.1 Not only was Congress concerned about the potential loss of revenue fromdeductions, which did not take into account the time value of money, but also it was concerned about the potential forabuse. n239 Congress responded to these concerns by enacting Section 461(h). Following that section's enactment in1984, revenue agents and taxpayers were generally uncertain as to how the rules should be applied in all but the mostobvious circumstances. However, on June 6, 1990, approximately six years after the enactment of Section 461(h), theTreasury issued proposed regulations. n240 Corresponding amendments were proposed for other related provisions inthe regulations. Ultimately, final regulations were promulgated, effective April 10, 1992. n241 Notwithstanding theenactment of the economic performance rules, circumstances may arise where application of the rules is considered toproduce such an inequitable result that the rule may not be applied by the courts. n241.1

P 4.04[3][a] Section 461(h)

Under Section 461(h), a taxpayer incurring an obligation for an item of expense will not be entitled to a deductionuntil economic performance has occurred with respect to that item. n242 As a general rule, where a taxpayer'sobligation consists of promising to pay for services or property provided to him or providing services or property toanother, economic performance occurs only as these services or property are provided. Under this section, a taxpayermay no longer obtain a tax deduction prior to the time of performance. Thus, this provision has the effect of resolvingmany of the issues that had arisen in the past with respect to identification of the relevant liability. n243

Although intended to prevent tax abuse, Section 461(h) applies to all taxpayers using an accrual method ofaccounting. It is not limited in scope to particular categories of taxpayers or to particular transactions. It applies evenwhere payment has already been made, i.e., except in certain designated instances, n244 payment is not economicperformance. The provision thus produces an anomalous result. It was, in large part, intended to correct the problem ofpermitting a deduction to be taken substantially in advance of payment; yet, it may deny a deduction even wherepayment has been made.

Perhaps in recognition of this anomaly, the Treasury has adopted a special rule to permit economic performance tooccur as payments are made in particular circumstances. n245 For example, under the special rule, a taxpayer may treatproperty or services provided to it as satisfying economic performance at the time payment is made, if the taxpayer canreasonably expect the person who is to provide the property or services to provide them within three and one halfmonths after the date of payment. This special provision is interesting in several respects. First, the property or servicesapparently do not actually need to be provided within three and one half months of payment as long as the taxpayer canreasonably expect the person who is to provide the property or services to provide them within three and one halfmonths after payment. Consequently, a failure to provide the property or services within the specified time frame shouldnot prevent the occurrence of economic performance at the time of payment, if the failure was not reasonably expected.Second, although the time of payment normally does not accelerate a deduction by an accrual method taxpayer, thisspecial rule allows accrual method taxpayers the opportunity for accelerating deductions merely by making payment.Thus, accrual method taxpayers should consider their tax postures as they near the end of each taxable year. Ifdeductions are desired, they may be able to accelerate certain deductions merely by making payment and takingadvantage of this special three-and-one-half-month rule. Alternatively, if they wish to defer a deduction until a lateryear, they may do so simply by deferring payment. Finally, it would appear that eligibility for this special rule does notin any way depend on satisfaction of the requirements pertaining to applicability of the recurring item exception. n246

Although an exception is provided for certain recurring items, n247 the Section 461(h) rules otherwise apply toeveryday business transactions as well as to transactions motivated wholly by tax considerations. With certain

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exceptions, n248 the section applies for all purposes of the Code, not just to deductions under Section 461. n249 Smalland large businesses as well as tax shelter transactions and transactions not associated with tax shelters are subject tothis new requirement of the all events test.

In many cases, economic performance will occur in the same taxable year in which the old requirements of the allevents test would be satisfied and, therefore, will not cause a deferral in the timing of deductions. When economicperformance does not occur in the same year, the recurring item exception may apply. n250 Nevertheless, everytransaction of every accrual basis taxpayer must now be examined in light of this relatively new requirement. It must bekept in mind that satisfaction of the economic performance requirement, whether with or without application of therecurring item exception, does not mean that the all events test has been satisfied. It is still incumbent on taxpayers toshow that they have satisfied both the fixed obligation and reasonable accuracy prongs of the all events test. n250.1

P 4.04[3][b] Time When Economic Performance Occurs

Section 461(h) provides rules for determining when economic performance occurs and exceptions to those rules. Inaddition, Congress has provided the Treasury with the authority to alter these statutory provisions. n251

Until regulations were finally adopted, effective April 10, 1992, the precise manner in which the general ruleswould apply was necessarily speculative. This was especially troublesome where, as here, the new test was alreadyeffective. n252 Nevertheless, general rules are provided by the statute, and on June 6, 1990, comprehensive regulationswere proposed. n253 Although the proposed regulations were subject to change before adoption (and they had been thesubject of numerous comments by practitioners and taxpayers), they provided significant additional guidance as to wheneconomic performance would occur.

Ultimately, final regulations were adopted. Together with the statutory provisions, these regulations covernumerous circumstances including where services or property are provided to the taxpayer, where services or propertyare provided by the taxpayer, and where workers' compensation or tort liability is involved. n254 The regulations alsoprovide that in any case where the statutory or regulatory rules do not provide the time when economic performanceoccurs, economic performance will be deemed to occur only as payment is made to the person to which the liability isowed. n255 It is anticipated that such instances will occur rarely and only in situations where the liability cannotproperly be characterized as one covered by other economic performance rules. n256

P 4.04[3][b][i] Services and property provided to taxpayer.

If a taxpayer's liability arises from its promise to pay for services or property provided by another, economicperformance is deemed to occur as such services or property are provided. n257 For example, if a taxpayer enters into acontract in year 1, which unconditionally obligates it to pay for services to be rendered to it in year 2, then unless anexception is applicable, the taxpayer will be entitled to the deduction only in year 2, as the services are rendered. If aportion of the services is rendered in year 2 and the balance is rendered in year 3, then economic performance will occurin years 2 and 3. Guidelines have not yet been provided as to how the cost of the total services should be allocatedbetween the two years. n258 However, the courts have indicated that practical solutions should occur. For example,where the services to be rendered are contingent in both timing and amount so that the amount of the liability cannotproperly be allocable to any of the affected years on an accurate basis until the obligation to provide services hasexpired, a reasonable approach to allocation should be permitted. n258.1

Care must be taken in evaluating the nature of each particular liability. For example, in IES Indus., Inc. v. UnitedStates, n258.2 an issue before the court involved the proper year for deducting the taxpayer's liability to make paymentsinto a fund providing for the decontamination and decommissioning of uranium-enrichment plants. Under a particularact of Congress, parties who received uranium-enrichment services from the Department of Energy were required to payfor various environmental cleanup costs by making payments into the fund. In the case of the taxpayer, the paymentswere expected to take place over a period of fifteen years. The issue was whether the entire liability could be deducted

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in the year in which the uranium-enrichment services were provided (assuming the taxpayer's liability arose out of theservices provided to it) or only as payments were made into the fund (assuming the liability did not arise out of suchservices). Focusing on the fact that the amount of the customer's liability was proportionate to the services receivedfrom the government, the court concluded that the taxpayer's liability arose out of the provision of services. Hence, thegovernment allowed the immediate deduction of the taxpayer's liability for cleanup costs. As this case demonstrates, thetiming of the deduction may well be driven by the actual agreement between parties or the language of relevantstatutory or regulatory authority. Hence, care should be taken in drafting language for such agreements or suggestinglanguage for legislation.

If the taxpayer's liability arises out of its use of property, economic performance occurs only as the taxpayer usesthe property. The use requirement initially raised a troubling interpretive question. If the taxpayer leased a building for aperiod of twelve months beginning December 1 of year 1, would the taxpayer be entitled to a deduction for one month'srent in year 1 if it did not actually occupy or otherwise use the leased premises during that month? Would availabilityfor use constitute use? It was feared that the IRS might take the position that the deduction for that rent should bedeferred until the period of actual use. n259

Ultimately, this question, together with others, was answered by the Treasury. On June 7, 1990, the Treasury issuedproposed regulations providing guidance as to how the economic performance rules would operate. n260 Finalregulations were adopted, effective April 10, 1992. n261 These regulations are discussed below. n262

P 4.04[3][b][ii] Services and property provided by taxpayer.

If the taxpayer's obligation is to provide property or services to another, economic performance occurs as thetaxpayer provides such property or services. n263 For example, if the taxpayer is obligated to repair or maintainproperty that it sells, economic performance occurs only as those repairs are made or as the maintenance is performed.Thus, absent an exception, taxpayers would not be entitled to deduct in the year of sale the estimated cost of carryingout warranty or similar obligations in the future. This also appears to have the effect of legislatively overruling thedecisions in a number of other cases. n264

On June 7, 1990, the Treasury issued proposed regulations providing guidance as to how the economic performancerule would operate. n265 Final regulations were adopted, effective April 10, 1992. n266 These regulations arediscussed below. n267

P 4.04[3][b][iii] Workers' compensation and tort liabilities.

If the taxpayer's obligation requires a payment to another as a result of any workers' compensation act or tortliability, economic performance occurs only as the payments are made. n268 Thus, the taxpayer is effectively placed onthe cash method with respect to such obligations. However, the taxpayer is not actually on the cash method becausesatisfaction of the economic performance test does not, of itself, permit a deduction. The liability to which the paymentrelates must be fixed. If payment precedes existence of a fixed liability, a deduction will not be allowed merely becauseof the payment.

However, if a taxpayer takes out insurance to cover such liabilities, economic performance will occur with respectto the taxpayer's liability to the insurance company as payments are made. n269 Thus, the taxpayer's deduction will notbe postponed until the insurance company itself makes payment to the injured person.

If the taxpayer satisfies its tort liability by purchasing an annuity for the benefit of the claimant, a question arises asto the time of economic performance. If the taxpayer delivers the annuity contract to the claimant in satisfaction of thetaxpayer's obligation, should economic performance be deemed to occur on delivery? If so, the amount of the deductionpresumably should be limited to the amount of the claim satisfied at the time of delivery of the annuity, and gain or lossmight arise to the extent of the difference between the amount of the claim satisfied and the taxpayer's basis in theannuity contract.

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On June 7, 1990, the Treasury issued proposed regulations providing guidance as to how the economic performancerules would operate. n270 Final regulations were adopted, effective April 10, 1992. n271 These regulations arediscussed below. n272

P 4.04[3][b][iv] Other items.

Section 461(h) sets forth the principles governing when economic performance occurs only in certain specifiedinstances. n273 The Code provides that, in all other instances, economic performance will be deemed to occur only asdetermined under Treasury regulations. n274 Thus, a taxpayer incurring an obligation that requires economicperformance in a manner other than as specifically set forth in the Code had no ascertainable standard for determiningthe period in which the deduction should be recognized prior to the issuance of Treasury regulations.

On June 7, 1990, the Treasury issued proposed regulations providing guidance as to how the economic performancerules would operate. n275 Final regulations were adopted, effective April 10, 1992. n276 These regulations arediscussed below. n277

P 4.04[3][c] "As Provided" Requirement

P 4.04[3][c][i] General rules and questions arising prior to issuance of regulations.

Taxpayers generally satisfy the economic performance requirement only as property or services are provided.Consequently, the requirement is not satisfied at the commencement of the rendition of services or the delivery ofproperty. Rather, assuming the other requirements of the all events test are satisfied, the taxpayer is entitled to adeduction in any particular year for only that portion of the total liability that may be attributable to the services orproperty actually provided in that taxable year. Because the "as provided" requirement is a facts-and-circumstances test,there is a considerable likelihood of disputes and controversies.

In many instances, it should be comparatively easy to apportion the liability to the activities performed in aparticular year. For example, with respect to many liabilities, economic performance would most likely be found tooccur ratably over time, e.g., rent and insurance. n278

In other instances, an appropriate apportionment may be more difficult to make, if not virtually impossible. Forexample, if a taxpayer becomes obligated to pay a fixed amount for certain services (such as legal, accounting, andengineering), the services may be of little value to the taxpayer until their completion. Alternatively, the obligation ofthe professional may be the preparation of an opinion, report, or other document. Until the document is delivered, thetaxpayer may believe it has received no service. In this sense, the question may be raised as to whether the taxpayershould be viewed as requesting a product.

Several questions arise in circumstances where the services result in the creation of such an intangible product.Should the taxpayer get a deduction as services are rendered (and payments made), or only on completion of theservices or delivery of the document? If deductions are permitted as the services are rendered, should apportionment bemade on some possibly arbitrary standard (such as time lapsed or hours spent) or on some other basis?

Example:

Assume a 10,000-foot well is to be dug for the taxpayer at a total cost of $80,000. If 2,000 feet are dug in year 1and the remaining 8,000 feet are dug in year 2, what portion of the $80,000 liability is attributable to the 2,000 feet dugin year 1? Is it determined simply on a pro rata basis, in which event it would be $16,000 ((2,000/10,000) x $80,000), orshould recognition be given to the fact that the cost of digging each foot may not be the same, i.e., the deeper footagemay cost more than the shallow footage?

The treatment of interest also poses interesting questions. The Joint Committee Explanation of the rules indicates

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that economic performance with respect to interest occurs with the passage of time rather than as payments are made. Itsuggests that interest incurred by accrual method taxpayers should be deductible on a so-called constant interest basis.n279 Although this seems reasonable if the agreement of the parties provides for an economic accrual of interest on aconstant rate basis, it would seem illogical and inappropriate to apply a constant rate approach if the agreement calls forinterest that varies according to a fixed standard, such as a prime rate or other rate tied to an accepted index. A constantrate approach would also appear inappropriate if the applicable agreement calls for different fixed interest rates (1) fordifferent periods of time or (2) on the basis of different levels of security. For example, if it is anticipated that the holderof the note may be secured by a first mortgage on property during some periods and by a second mortgage during otherperiods, it would seem appropriate that the applicable interest rate vary in accordance with the relative risks during therelevant periods of the loan. Similarly, use of a constant rate, while perhaps consistent with some economic analyses,may be inconsistent with the agreement of the parties, applicable nontax laws, or other factors. These circumstancesshould not be ignored in applying the economic performance requirement. n280

In some cases, questions may arise over the character of the item to which the liability relates. To illustrate, assumethat in year 1, a taxpayer purchases season tickets for sporting events, concerts, or similar events to be performed in year2. An initial question is whether the taxpayer has purchased services or property. If the tickets represent a right toservices to be rendered in the future, will the taxpayer's deduction be deferred until the year in which the performanceoccurs? If the tickets are property, will the taxpayer be entitled to a deduction in the year the tickets are acquired? Whatlaw will be applied in determining whether the taxpayer has obtained property or a right to receive services? Will theyear of deduction be affected by whether the taxpayer acquires the tickets for itself, gives them to its employees, orprovides them to customers or clients? To what extent will the taxpayer's intent be relevant? Until clarifying regulationsor other authorities address these questions, taxpayers can only speculate as to the ultimate answer. Presumably,taxpayers will characterize the item in the manner most favorable to them and await a challenge on audit.

P 4.04[3][c][ii] Applicable treasury regulations.

The Treasury adopted final regulations, effective April 10, 1992, providing guidance on the manner in which theeconomic performance rules would apply. n281 These regulations focus on how the "as-provided" requirements of theeconomic performance rules will be interpreted.

Services and property provided to the taxpayer.The regulations confirm the principle established in Section461(h)(2)(B) that if the liability of a taxpayer arises out of the provision of property or services by another, economicperformance occurs as the property or services are provided to the taxpayer or to another person at the taxpayer'sdirection. n282 However, the regulations provide two exceptions that may accelerate the time when economicperformance will be deemed to occur from the time the property or services are provided to the time payment is madeby the taxpayer.

First, if the expense incurred by the taxpayer is attributable to a long-term contract with respect to which thetaxpayer uses the percentage-of-completion method, economic performance will occur at the earlier of the time theproperty or services are provided or the time the taxpayer makes payment in satisfaction of the liability to the personproviding the property or services. n283 This provision, although suggesting an acceleration in the time when liabilityis taken into account, actually has the effect of accelerating the taxpayer's recognition of income. Simply stated, byaccelerating the time when the expenses are taken into account, the provision accelerates the time when thecorresponding income will be recognized under the percentage-of-completion method.

Second, a special rule is provided allowing the taxpayer to treat property or services as being provided at the timethat the taxpayer makes payment for the property or services, if the taxpayer can reasonably expect the person who is toprovide the property or services to provide them within three and one half months after the time of payment. n284Literally, this rule does not require that the property or services actually be provided within three and one half months;only that the taxpayer reasonably expect property or services to be provided within three and one half months afterpayment. This provision is a special rule, separate and apart from the recurring item exception. n285

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Each of these special rules requires taxpayers to consider carefully the timing of their payments. Moreover, thewording of these rules raises various interpretive questions. For example, the first special rule appears to be mandatorywhereas the second rule appears to be permissive. If the second rule is permissive, the taxpayer's initial decision to treateconomic performance as occurring at the time of payment (or not to treat payment as the term of economicperformance) may constitute the adoption of a method of accounting. Thus, if a taxpayer treats payments as constitutingeconomic performance where services or property are reasonably expected to be delivered within three and one halfmonths of payment, the taxpayer may not thereafter have the option of ignoring payments in determining wheneconomic performance occurs. On the other hand, the taxpayer can take these rules into account on an ongoing basis indeciding whether to make a payment.

Use of property by taxpayer.If the liability of the taxpayer arises out of the use of property, economic performanceoccurs ratably over the period that the taxpayer is entitled to use the property. n286 By clarifying that the economicperformance occurs over the period the taxpayer is entitled to use the property rather than over the period of actual use,the regulation clarifies the fact that it is the right to use the property and not the actual use that controls. Thus, if ataxpayer enters into a lease to occupy property beginning December 1 of year 1 but does not occupy the property untilJanuary of year 2, economic performance would be deemed to accrue ratably beginning December 1 of year 1 eventhough the taxpayer did not actually use the property during that month.

By making economic performance occur ratably as the property is used, taxpayers are apparently precluded fromarbitrarily structuring lease payments in such a way as to accelerate the amount of deduction for which economicperformance will be deemed to have accrued. In other words, the taxpayer may not be able to pay a premium for thefirst month's rent and declining amounts of rent thereafter and thereby accelerate deductions disproportionately toearlier portions of the lease term. On the other hand, if a multi-year lease agreement provides for annual or less frequentadjustments to the rent, based on changes in underlying costs and similar factors normally giving rise to such changes,the resulting changes in rent should be taken into account ratably over the period to which they relate. Bona fidechanges occurring more frequently than annually should be examined carefully to determine how and when they shouldbe taken into account.

Special rule regarding purchases of property or purchases of multiple items of property or services.The regulationspermit a taxpayer to treat property as provided when the property is delivered to the taxpayer, accepted by the taxpayer,or when title to the property has passed to the taxpayer. n286.1 Whichever method is used by the taxpayer to determinewhen property is provided constitutes a method of accounting from which the taxpayer may not change without theprior approval of the Commissioner. n287 This rule may be somewhat inconsistent with normal principles governingwhen a sale occurs and when property is acquired by a taxpayer. n288 It is not yet known whether the Treasuryproposes to apply this rule without regard to changes in facts and circumstances so that any approach used must be usedin all cases. Such an interpretation, if made, would be inconsistent with normal interpretations of methods ofaccounting. n289

Under a second special rule, if a taxpayer is to receive different services or items of property under a singlecontract, economic performance generally occurs over time as each service is provided or as each item of property isprovided. However, if such service or property is incidental to other services or property to be provided under theagreement, the taxpayer is not required to allocate any portion of the total contract price to such incidental services orproperty. For this purpose, property or services are treated as incidental only if (1) the cost of the property or services istreated on the taxpayer's books and records as part of the cost of the other property or services provided under thecontract and (2) the aggregate cost of the property or services does not exceed 10 percent of the total contract price.n290 Consequently, the regulation implies that in the cases not covered by this special rule, an allocation of the contractprice must be made among the various items of property and services to be provided. Such a requirement may give riseto numerous controversies involving both the allocations made and the time when economic performance occurs foreach particular item of service or property.

Services and property provided by the taxpayer.Section 461(h)(2)(B) provides the general rule that if the taxpayer's

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obligation is to provide property or services to another, economic performance occurs as the taxpayer provides suchproperty or services. The regulations clarify this statutory provision by providing that economic performance in suchcases will occur as the taxpayer incurs costs in connection with the satisfaction of the liability. n291 In determiningwhether the taxpayer has incurred costs, the regulations refer to the general rules for accrual method taxpayers as setforth in Treasury Regulation § 1.446-1(c)(1)(ii). As a result, taxpayers would be deemed to incur costs when all theevents had occurred that established the fact of liability, when the amount could be determined with reasonableaccuracy, and when economic performance had occurred with respect to that liability.

This rule requires an evaluation of two separate liabilities, the liability of the taxpayer to provide property orservices to another (the first liability) and the liability of the taxpayer to those who provide property or services to thetaxpayer so that the taxpayer will be able to satisfy the first liability. To illustrate, assume that a calendar year, accrualmethod taxpayer sells property under a warranty. Assume that the property is sold in year 1, that a defect, whichrequires the taxpayer to replace certain parts, occurs in year 2, that the taxpayer incurs costs to its own employeesduring year 3 as they manufacture the replacement parts, and that the actual replacement occurs in year 4. In thesecircumstances, economic performance with respect to the taxpayer's obligation to its customer (the first liability) beginsto occur in year 3 as the taxpayer incurs costs associated with the property to be provided to the customer. n292

Barter transactions.If the taxpayer is required to provide services or property or the use of property as a result ofthe taxpayer's use or receipt of property or services from another, economic performance occurs to the extent of thelesser of two amounts. n293 The first amount is the cumulative extent to which the taxpayer incurs costs in connectionwith its liability to provide property or services, and the second amount is the cumulative extent to which the propertyor services are provided to the taxpayer. To illustrate, assume a taxpayer agrees to pay a worker $20 per hour to provideservices to another person in consideration for that other person providing the taxpayer with property worth $20 perunit. If the taxpayer incurs $40 of liability to the worker during year 1 for services provided to the other person and theother person had provided the taxpayer with only one unit or $20 of property during year 1, economic performance hasoccurred during year 1 to the extent of the $20 of property received, the lesser amount. If the situation were reversedand two units of property had been received but only one hour of the worker's time had been spent, economicperformance would have occurred to the extent of the $20 of services. This rule may result in a taxpayer not having abasis in the property acquired until the taxpayer itself has provided property or services. To illustrate, assume that thetaxpayer does not provide property or services until after it has disposed of the property it received, the taxpayerpresumably would recognize gain in connection with the disposition of property for which it has no basis. This couldpose serious financial difficulty where this rule applies and none of the exceptions for accelerating the time of economicperformance are otherwise applicable.

Payment as economic performance.The regulations specify that except where economic performance is deemed tooccur in some other fashion, economic performance will arise as payments are made. In other words, unless thetaxpayer can identify a particular provision providing for a different time for economic performance, economicperformance will occur as payments are made in satisfaction of the particular liability. Thus, payment is a catchall rulefor economic performance where no other rule applies. n294 Of course, the regulations provide specific rules governingwhen economic performance occurs in the majority of cases, such as when the liability arises out of the use or receipt ofthe property or services. Thus, the Treasury anticipates that this catchall provision will not apply in that manycircumstances.

The regulations nevertheless identify five specific instances that will be covered by the payment rule. First,economic performance occurs as payment is made in the case of any liability arising under a worker's compensation actor out of any tort, breach of contract, or violation of law. n295 For a liability to pay for services, property, or otherconsideration provided under a contract, the liability is not considered a liability arising out of a breach of that contractunless the payments made are in the nature of incidental, consequential, or liquidated damages. n296 However, aliability arising out of a tort, breach of contract, or violation of law includes a liability arising out of the settlement of adispute in which a tort, breach of contract, or violation of law is alleged. n297 These various categories of liabilities aremuch broader than those identified in the Section 461(h), itself, which pertained only to worker's compensation and tort

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liabilities. The regulations also provide that none of the liabilities coming within this category is eligible for therecurring item exception. n298

Second, economic performance occurs as payment is made in the case of liabilities to pay a rebate or refund toanother person (without regard to whether the liability is paid in property, money, or a reduction in the price of goods orservices to be provided in the future). n299 This rule applies to all rebates, refunds, and payments or transfers in thenature of the rebate or refund regardless of whether they are characterized as a deduction from gross income, anadjustment to gross receipts or total sales, or an adjustment or addition to cost of goods sold. In the case of a rebate orrefund taking the form of a reduced price for goods or services to be provided in the future, payment is deemed to occurat the time the taxpayer otherwise would be required to recognize income resulting from the provision of services or theproviding of goods. The recurring item exception is available for this type of liability.

Third, economic performance occurs as payment is made if the liability of a taxpayer is to provide an award, prize,jackpot, or similar payment. n300 The recurring item exception is available for this type of liability.

Fourth, economic performance occurs as payment is made in the case of a liability arising out of the provision tothe taxpayer of insurance or a warranty or service contract. n301 "Warranty" or "service contract" is defined as acontract entered into in connection with property purchased or leased by the taxpayer pursuant to which the other partypromises to replace or repair property under specified circumstances. The term "insurance" has the same meaning as ithas under Section 162. The recurring item exception is available for this type of liability.

Fifth, economic performance occurs as payments are made in the case of a liability to pay a tax. n302 (The onlyexceptions to this rule are for foreign taxes and real estate taxes subject to the election under Section 461(c)). n303 Forpurposes of this rule, a tax does not include a charge collected by a governmental authority for specific extraordinaryproperty or services provided to a taxpayer by the governmental authority, including for example charges for land soldto the taxpayer or for the labor of government employees who improved the land. The recurring item exception isavailable for these liabilities.

In applying these various payment rules, a number of principles of cash basis accounting are adopted. n304 Ingeneral, the term "payment" has the same meaning as it has in applying the cash method. n305 Consequently, paymentincludes the furnishing of cash or a cash equivalent. Payment should also include the providing of property for services.However, payment will not include the furnishing of a note or other evidence of indebtedness of the taxpayer, whetheror not that note or other evidence of indebtedness is guaranteed by a third person or by some other instrument, includinga standby letter of credit. Payment also will not include an amount transferred in a fashion other than as payment (e.g.,as a loan, refundable deposit, or a contingent payment that may be refunded or otherwise credited back to the taxpayer).n306

Although satisfaction of the foregoing rules generally would determine whether a payment has been made for cashbasis taxpayers, the regulations apparently impose an additional requirement in order for the taxpayer to be treated ashaving made payment. Under the regulations, payment is accomplished by satisfaction of the principles set forth in thepreceding paragraph and by showing that, if the person to whom the payment is made were a cash basis taxpayer, thepayment would be treated as having actually or constructively been received by that person so that the amount of thepayment would be includable in that person's gross income. n307 To illustrate, if the taxpayer were to purchase anannuity contract or other asset, that purchase would not be regarded as a payment to the person to whom the liability isowed unless the ownership of the contract or other asset was transferred to that person. n308 It is not known whetherthe constructive receipt rules will be deemed to preclude economic performance from having occurred in othersituations where a payment may have been made directly to the person to whom the liability is owed, but where,because of unusual circumstances, that person is not deemed to have actually or constructively received the payment inthe same year. n309

The regulations also specify when payment will be deemed to have occurred in the case of liabilities that are

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assumed in connection with the sale of a trade or business. In general, if the purchaser expressly assumes a liabilityarising out of the trade or business and the seller would have been entitled to accrue that liability as of the date of sale(but for the economic performance requirement), then the taxpayer-seller will be deemed to have made payment withrespect to the liability as the amount of the liability is included in the amount realized from the sale by the taxpayer.n310 For purposes of this provision, "trade or business" is defined as a specific group of activities carried on by thetaxpayer for the purpose of earning income or profit if every operation that is necessary to the process of earning thatincome or profit is included in such group, e.g., the group of activities generally must include the collection of incomeand the payment of expenses. n311 However, to further complicate matters, the special rules regarding payment in thecase of liability assumed in connection with the sale of a trade or business will not apply if the District Directordetermines that tax avoidance was one of the taxpayer's principal purposes for the sale of the trade or business. n312

Effective dates.As a general rule, the regulations apply to liabilities that would, under the law in effect before theenactment of Section 461(h), be allowable as a deduction or otherwise be incurred after July 18, 1984. n313

However, the rules governing liabilities for which payment constitutes economic performance (other than liabilitiesarising under a worker's compensation act or out of any tort) generally apply to liabilities that would be allowable as adeduction or otherwise be incurred for tax years beginning after December 31, 1991. n314 Thus, there is no Section481 adjustment with respect to the application of this effective date and, instead, a cutoff approach is used. However,the regulations provide an alternative permitting a taxpayer to elect to treat the change as a full-year change in methodof accounting pursuant to the procedures of Temporary Regulation § 1.461-7T, subject to the conditions of Section 4 ofRevenue Procedure 84-74. n315

P 4.04[3][d] Proof of Compliance With Economic Performance Test

An obvious concern among taxpayers is the degree of additional record keeping that the economic performance testentails. Some guidance is provided in the legislative history of the provision, which states that enforcement ofcompliance with the economic performance standard should be carried out in a manner that does not impose substantialadditional record-keeping burdens on the taxpayers. n316 Nevertheless, taxpayers must be able to demonstrate wheneconomic performance actually occurred with respect to an obligation.

The legislative history indicates that except in unusual circumstances, a taxpayer may establish the fact ofeconomic performance at a particular time by reference to a valid contract that requires economic performance at thattime. Although the contract apparently is not required to be in writing, a taxpayer may be well advised to reduce thecontract to writing to establish proof of compliance. A contract should be valid for these purposes if the fact of thelitability is fixed under applicable state law. The legislative history refers only to the valid contract rule for services orproperty to be provided to the taxpayer. However, the rule should be equally available in the case of a taxpayer whoseobligation is to provide services or property.

The legislative history also indicates that a more lenient compliance standard may be applied where the item atissue involves a foreign corporation. n317 Because information regarding economic performance may need to comefrom third parties, it may be difficult for a U.S. taxpayer to obtain that information, particularly when the U.S. taxpayerowns only a minority interest in the foreign corporation. Of course, it may be equally difficult for U.S. taxpayers toobtain information from other U.S. taxpayers.

P 4.04[3][e] Impact on Other Than Current Deductions

Section 461(h) provides that for all purposes of the income tax laws, an item is not incurred (or taken into account)until economic performance has occurred. As a result, this provision may affect other sections of the Code where it isimportant to determine when an item has been incurred. The intended broad application of Section 461(h) wasconfirmed in regulations proposed by the Treasury on June 7, 1990, and adopted, effective April 10, 1992. Theseregulations include an amendment to the general rules governing application of accrual methods under Section 446 and

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provide that the term "liability" includes any item allowable as a deduction, cost, or expense for federal income taxpurposes. n318 Thus, the regulations would affect any amount that would be allowable as a capitalized cost, a cost tobe taken into account in computing cost of goods sold, a cost allocable to a long-term contract, or any other cost orexpense including, for example, any amount that the taxpayer spends or will spend for capital improvements to propertywhere the amount must be incurred before the taxpayer may take it into account in computing the basis of property.n319 Thus, the regulations answer a number of questions. For example, assume a taxpayer incurs start-up costs inconnection with a new trade or business and that certain of these costs involve obligations for which economicperformance will not occur until after the trade or business has commenced. Should the taxpayer capitalize the expenseand amortize it over sixty months as a start-up cost under Section 195. Section 461(h)(1) may require that the amount betreated as incurred only when performance occurs, which in this case would be after the trade or business hascommenced. The regulations suggest that this result is exactly what is required.

Assume that a taxpayer subdivides real property and begins selling lots and that he is contractually obligated tomake future improvements to lots that have already been sold. Under Revenue Procedure 75-25, he would have beenpermitted to add the estimated costs of the future improvements to the basis of the property in determining gain or lossfrom sales. n320 However, pursuant to Section 461(h), these costs should apparently be taken into account only afterthe improvements have been made. The regulations address these and other troubling questions. For example, theregulations make it clear that because economic performance must occur in order for a liability to be taken into account,the estimated cost of future improvements to subdivided real estate may not be added to the basis of lots sold ifeconomic performance has not occurred with respect to these costs. Therefore, the regulations make it clear that Section461(h) overrules Revenue Procedure 75-25. However, pursuant to its authority under Section 7805(b), the Treasuryinitially made this result effective prospectively only for taxable years beginning after December 31, 1989. n321

Following the issuance of this proposed regulation, the IRS decided that it needed to study further the specialcircumstances of subdividers of real estate. Accordingly, the IRS issued Notice 91-4, n322 in which it announced thatRevenue Procedure 75-25 would remain in effect until the issuance of further rules. As a result, subdividers of realestate were permitted to continue to request permission from the District Director to add to the cost or other basis ofproperty sold the estimated cost of future improvements in accordance with that revenue procedure. For sales ofproperty after December 31, 1990, subdividers who did not obtain such permission pursuant to Revenue Procedure75-25 were bound by the economic performance rules. For sales of property prior to January 1, 1991, the IRS would notapply the economic performance rules to prevent the inclusion in the actual cost or other basis of property sold anyestimated cost for future improvements to the extent those costs would have been included in basis under the law as itexisted prior to the enactment of the economic performance rules. At the time the final regulations were adopted, theIRS notified taxpayers that special rules would be provided in a forthcoming revenue procedure. n323

P 4.04[3][f] Exception for Certain Recurring Items

Section 461(h)(3) provides an exception under which certain expenses will be treated as incurred (and, hence, willbe deductible in the taxable year in which the all events test is otherwise satisfied) without regard to whether economicperformance has occurred. n323.1 This exception is not applicable to liabilities arising as a result of workers'compensation or tort claims. n324

The exception applies and the deduction is required if the following criteria are satisfied: n325

The all events test is otherwise satisfied without regard to economic performance.

Economic performance with respect to the obligation in question occurs on or before the earlier of (1) the date thetaxpayer files a timely return (including extensions) for the taxable year or (2) eight and one half months after the closeof such taxable year.

The item is recurring in nature.

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Either (1) the item is not a material item or (2) the accrual of such item in the taxable year in which the all eventstest is otherwise met results in a more proper match against income than accruing the item in the taxable year in whicheconomic performance occurs.

The recurring item exception is mandatory, not permissive or elective. Thus, a taxpayer who fails to claim adeduction in the year permitted under the exception will be denied the deduction in a later year.

P 4.04[3][f][i] Timely return or eight and one half months.

Section 461(h)(3)(A)(ii) sets forth the rule that the recurring item exception applies if economic performanceoccurs within the shorter of a reasonable period or eight and one half months after the close of the taxable year. Theterm "reasonable period" is not defined in the statute or the legislative history. It was reasonable to assume that afacts-and-circumstances test would be employed. However, recognizing that application of such a test would createnumerous practical problems, the Treasury promulgated a different rule in its regulations, which is discussed below.

The eight-and-one-half-month period in the Section 461(h)(3) requirements presumably was chosen because it isthe same as the maximum period for which extensions of time may be obtained within which to file returns. n326Assuming these extensions are filed, Congress apparently believed that taxpayers would be able to determine whethereconomic performance had occurred within the eight-and-one-half-month period. This assumption is not accurate inmany cases. Assuming economic performance occurs near the end of the eight-and-one-half-month period, manybusinesses (or the persons responsible for preparing the return) will not know of the economic performance until afterthe period for filing returns has expired.

Effect of regulations.In an effort to simplify the application of this requirement, the regulations have made anumber of changes to the statutory rule. First, economic performance must occur on or before the earlier of (1) the datethe taxpayer files a timely (including extensions) return for that taxable year or (2) eight and one half months after theclose of that taxable year. n327 Moreover, if the taxpayer files a return before the running of the eight and one halfmonth period and economic performance occurs thereafter but within the eight-and-one-half-month period, an amendedreturn may be filed for the year claiming the benefit of the recurring item exception. n328

As a result of this simplification, taxpayers do not need to focus on whether the liability has occurred within areasonable period after the close of the taxable year. The application of this rule may cause taxpayers to delay filing thereturn until the end of the eight-and-one-half-month period and thereby avoid the need to consider the filing of amendedreturns.

On the other hand, literally, the language governing the filing of an amended return is discretionary. Therefore,even though use of the recurring item exception constitutes a method of accounting, taxpayers may be able to have theexception apply or not based on the time the original return is filed. For example, if the taxpayer expects economicperformance to occur within eight and one half months but would prefer to delay the deduction, the taxpayer apparentlymay do so merely by filing the original return before economic performance has occurred and not thereafter filing anamended return.

P 4.04[3][f][ii] Recurring nature.

The exception is available only for items that are recurring in nature. Section 461(h)(3)(A)(iii) includes within thecriteria for application of the recurring item exception that the items must not only be recurring in nature but also thatthey must be treated consistently with similar items. However, the regulations dropped the consistency portion of thisrequirement. n329

Recurrence.The legislative history does not describe the type of items that are considered to be recurring. Twoimmediate questions that arise are (1) whether the item must recur every year or virtually every year and (2) whether thedollar amount (or fluctuations in the dollar amount) of the item is relevant. As to the first question, the legislative

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history provides that in determining whether an item is recurring, consideration must be given to the frequency withwhich that item or similar items are incurred or expected to be incurred. n330 However, the legislative history alsoprovides that an expense that does not recur every year should not necessarily be excluded from the exception. n331 Asexplained below, the regulations follow this approach.

As to the second question, no guidance is provided. Thus, a taxpayer who regularly incurs routine legal oraccounting services each year has no guidance as to whether an extraordinary expense incurred for an unusual legal oraccounting service will be treated as recurring in nature.

Consistency.Under the statute, a taxpayer could not satisfy the consistency test solely by reference to the treatmentof a specific item. Rather, the taxpayer had to treat consistently all items of such kind as incurred in the year the allevents test was otherwise satisfied without regard to economic performance. The phrase "items of such kind" was notdefined by the legislative history.

Effect of regulations.The regulations provide some guidance on whether liabilities are recurring in nature. n332They specify that a liability is recurring in nature if it generally can be expected to be incurred from one taxable year tothe next. However, a taxpayer may treat a liability as recurring even if it is not incurred by the taxpayer in each taxableyear. In addition, a liability that has not previously been incurred by a taxpayer may be treated as recurring in nature if itis reasonable to expect the liability to be incurred on a recurring basis in the future.

P 4.04[3][f][iii] Not a material item or a more proper match.

For the exception to apply, either the item must not be a material item or its deduction in the earlier year must resultin a more proper matching of income and expense.

Materiality.In determining the materiality of a particular item, the IRS is to consider the size of the item, both inabsolute terms and in relation to the taxpayer's income and other expenses. n333 The IRS is also to consider thetreatment of the item on the taxpayer's financial statements. An item is considered material for tax purposes if it isconsidered material for financial statement purposes. n334 However, the converse is not true. An item that is notconsidered material for financial statement purposes may nevertheless be considered material for tax purposes. n335

The materiality of an item is to be determined separately with respect to each activity. For items that are notdirectly related to an activity (such as overhead items that may be related to several activities), the items of expense areto be tested against the aggregate of the activities. This determination of materiality requires the taxpayer to identifyeach activity separately. Thereafter, the taxpayer must apportion its direct income and expense between the variousactivities. Neither the legislation nor its history addresses how items of income and expense are to be apportionedamong activities and whether similar activities are to be aggregated. The legislative history is also unclear regardingwhether materiality is to be tested with respect to each item of expense or whether all items of similar expense are to beaggregated before applying the materiality test. Presumably, all expenses of the same type or similar items should beaggregated; otherwise, it would be easy to avoid this requirement.

The legislative history provides that in appropriate circumstances and to the extent provided in regulations, an itemis to be considered immaterial only if it is not material when analyzed at both the partnership and the partner level, thetrust or estate and beneficiary level, or the S corporation and shareholder level, as the case may be. n336 Untilregulations are promulgated with respect to this issue, the test of materiality should be made in each case at both theentity level and the partner or beneficiary level. Congress provided little guidance in determining when the test is notrequired to be applied at both levels. The sole illustration provided in the legislative history pertains to the situation inwhich an accrual basis partnership specially allocates to a partner an item that is not material to the partnership but ismaterial to the partner. n337 Whether this situation is in fact an appropriate one in which to test materiality at bothlevels would seem to depend on other factors. For example, it would not appear to be appropriate to apply themateriality test at both the partner and partnership level if the special allocation had been a part of the partnership

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agreement from the outset and the item had unanticipatedly increased in that year owing to business exigencies.

The legislative history further provides that this rule is not intended to impose significant additional reportingrequirements on pass-through entities in nonabusive situations. In that regard, many partnerships allocate net income orloss rather than each specific item of income, deduction, loss, or credit. As a result, it would appear to be extremelydifficult for a partner to identify each particular item that must be tested for materiality. Also, it is important to note thatthe focus is on nonabusive situations, not tax shelters. Therefore, in determining whether an abusive situation exists,taxpayers apparently must look at each transaction independently rather than at the overall operation of the activity.Several unanswered questions remain. Is the determination of a transaction as abusive or nonabusive to be tested at thepartner level or the partnership level? Is the term "abusive," to be defined by reference to the intent of the partner orpartnership or is it an objective determination made by reference to the result of the transaction?

More proper match.Even if the item is material, the exception provided in Section 461(h)(3)may nevertheless beavailable if the deduction of the item in a taxable year prior to the year of economic performance results in a moreproper match against income than deducting the item in the later year in which economic performance occurs.

GAAP is to be an important factor, although not necessarily a conclusive factor, in determining whether the accrualof an item in a particular year results in a better matching of the item with the income to which it relates. Thus, a strongpresumption may be given to GAAP for this purpose. This standard appears to be significantly different than thepresumption given GAAP in determining materiality. This difference appears only in the legislative history, not in thelegislation itself. n338 Section 461(h)(3)(B) provides only that in making the determination of materiality andmatching, the treatment of the item on the financial statement of the taxpayer must be taken into account.

Congress recognized that certain items (e.g., rent and insurance) are inherently period costs. For example, the rentattributable to a twelve-month lease entered into on December 1 of year 1 by a calendar-year taxpayer normally wouldbe allocated (1/12) to year 1 and (11/12) to year 2. Other costs (e.g., advertising costs) cannot practically be associatedwith the income in a particular period but under GAAP are assigned to the period in which the costs are incurred. Withrespect to these costs, the matching requirement is to be satisfied if the period to which the expenses are assigned for taxand financial reporting purposes are the same.

Effect of regulations.The regulations provide that in determining whether a liability is material, considerationshould be given both to the amount of the liability in absolute terms and the amount of the liability as related to otheritems of income and expense attributable to the same activity. n339 Moreover, the proposed regulations specify that aliability will be treated as material if it is material for financial statement purposes under GAAP, but a liability that isimmaterial for financial statement purposes under GAAP may nevertheless be material for purposes of recurring itemexception.

With respect to the matching requirement, the regulations specify that the matching principle of financialaccounting is an important but not dispositive factor. However, the regulations go on to specify that in the case ofrebates and refunds, awards, prizes and jackpots, insurance, warranty and service contracts, and taxes, all of whichrequire payment for determination of economic performance, the matching requirement will be deemed satisfied. n340

In conclusion, accrual method taxpayers must now satisfy three independent requirements before deduction of anexpense will be permitted. Cases that have permitted particular deductions in the past may now serve as precedent indetermining whether the first two requirements have been satisfied. Satisfaction of the third requirement, economicperformance, involves an entirely new analysis and increases the divergence between accrual accounting for financialand tax purposes.

P 4.04[3][f][iv] Adopting the recurring item exception.

The proposed regulations provided a number of rules regarding the time and manner of adopting the recurring itemexception. n341 If a taxpayer had never incurred a particular type of liability prior to the first taxable year beginning

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after December 31, 1989, the taxpayer could adopt the recurring item exception for that type of liability but only for thetaxpayer's first year beginning after December 31, 1989, in which that type of liability had been incurred. If a particulartype of liability had been incurred prior to December 31, 1991, the taxpayer was granted the consent of theCommissioner to change to the recurring item exception for that type of liability beginning with the taxpayer's firsttaxable year beginning after December 31, 1991. In either of these cases the recurring item exception had to be adoptedas prescribed in Q&A-7(b) of Temporary Regulation § 1.461-7T, applied by substituting the appropriate taxable yeardescribed above for "the taxable year that includes July 19, 1984" and any resulting Section 481 adjustment had to betaken into account ratably over a three-year period. In all other cases, any change to or from the recurring itemexception was a method of accounting subject to the normal rules governing changes in methods of accounting.Ultimately, final rules for adopting the recurring item exception were promulgated. n342 In general, these new rulesprovide that a taxpayer may adopt the recurring item exception merely by accounting for applicable items under therecurring item method. There will be no need to file a written statement.

Although the use of the recurring item exception constitutes a method of accounting, it should be noted that thestatutory language governing the recurring item exception is mandatory, i.e., it provides that an item shall be treated asincurred if the recurring item exception is met. Consequently, the possibility arises that a failure to use the recurringitem exception where a taxpayer is eligible for it constitutes the use of an improper method of accounting.

P 4.04[4] Items Where Payment Is Doubtful

An accrual method taxpayer is not obligated to accrue and include in income items whose collection is reasonablyin doubt. n343 On the other hand, the courts have made it clear that with limited exceptions, the inability of a taxpayerto pay an expense is not a reason for denying deduction of that expense. n343.1 Some courts hold this to be a firm rule.n344 Other courts appear less willing to adopt an absolute rule, suggesting by their decisions that inability to pay isirrelevant as long as a reasonable belief existed at the time the obligation was incurred that it would be paid. n345 In atleast one case, the court concluded that the liability was deductible even though it was certain at the time of deductionthat the liability would not be paid. n346 In this same vein, deductions have not been denied where the ability of theobligor to pay is not in question, but because of other circumstances it was clear that the full amount of the obligationwould not, in fact, be paid. n346.1

Although the IRS has challenged deductions in various circumstances on the basis that the amounts accrued anddeducted could not reasonably be expected to be paid, it too has recognized that inability to pay is generally notrelevant. n347 Thus, although questions can certainly be raised about particular circumstances, it seems quite clear thatinability to pay does not preclude accrual and deduction of the liability. This is appropriate. Since the tax is imposed onincome, it would be illogical to approve a deduction to those who can pay but deny a deduction to (and, hence, increasethe income of) those who cannot pay. n347.1

Nevertheless, in particular circumstances, some courts have denied the accrual and deduction of a liability. Thisdenial is appropriate, for example, where the liability is itself contingent on an ability to pay. Thus, where payment is indoubt, deduction may be denied. n348

Similarly, where the existence of a fixed liability is dependent upon the existence of assets available to pay theclaims, a deduction may be denied unless and until such assets exist. n348.1 In West Texas Marketing, the issue was thedeductibility of the post-petition interest of a debtor in a Chapter 7 bankruptcy liquidation. Although the creditor'sclaims (on which the interest would run) were clearly fixed under state law, the court pointed out that once the petitionin bankruptcy was filed, federal law controlled and that federal law would not fix the obligation of the debtor forinterest on such claims unless assets existed with which to pay that liability for interest. The court explained that theissue was not whether the taxpayer was able to pay a fixed liability but whether the liability was itself fixed. Themajority was influenced by the fact that, under bankruptcy law, interest stops accruing at the date of the filing of thepetition. Thus, there was a condition precedent to the existence of a fixed liability--the availability of assets out ofwhich to pay the interest. n348.2 The dissent, on the other hand, was influenced by the fact that there was no assertion

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by the government (nor concession by the taxpayer) that the interest would not be paid and there was no question as tothe liability for the obligations. In other words, in the dissent's view, the existence of assets related only to the taxpayer'sability to pay. n348.3

Also, a denial may be appropriate because of the relationship of the parties. For example, in Tampa & Gulf CoastRailroad v. Commissioner, n349 a subsidiary had accrued interest on a debt owed to its parent. The subsidiary arguedthat its inability to pay the accrued interest should not bar its ability to take an interest deduction. However, the courtheld that in the context of the parent-subsidiary relationship (when the same party is on both sides of the transaction andthus able to control payment of the debt) the general rule should not apply. n350

One of the most troubling cases is Mooney Aircraft, Inc. v. United States, n351 where the taxpayer issued a $1,000bond to customers when they purchased a plane. The bonds were payable on retirement of the planes, which could befifteen, twenty, or thirty years after purchase. The court could have found that the liability did not become fixed untilthe plane was retired, but it did not so conclude. Rather, it denied the deduction for what it held to be a clearly fixedliability whose amount could be determined with reasonable accuracy. Denial of the deduction was based on the factthat the time for payment was to be delayed for so long a time that deduction would be inappropriate and not clearlyreflect income. n352 This case has always posed a problem for courts and commentators because it denied a deductioneven though it found the all events test to have been satisfied. n353

The problem was recently exacerbated by the Tax Court's decision in Ford Motor Co. n353.1 There, the courtassumed that the all events test had been satisfied but nevertheless denied the taxpayer a deduction of the amounts towhich it would otherwise have been entitled on the basis that a deduction of the full amount would fail to reflect incomeclearly. In effect, the result produced in Ford Motor Co. was similar to the results that would have been achieved if thedeductions were limited to the present value of the amounts to be paid. Interestingly, the payments in Ford Motor Co.were to begin soon after the liability had become fixed even though they were to continue for a fairly long period.n353.2

If a liability is not paid and is ultimately forgiven, compromised, discharged in bankruptcy, or terminated by therunning of the applicable period of limitations, income may be recognized by application of the tax benefit rule. n354

FOOTNOTES:

n159 Treas. Reg. § 1.461-1(a)(3) provides that a "taxpayer may not take into account in a return for a subsequenttaxable year liabilities that, under the taxpayer's method of accounting, should have been taken into account in a priortaxable year. If a taxpayer ascertains that a liability should have been taken into account in a prior taxable year, thetaxpayer should, if within the period of limitation, file a claim or credit or refund of any overpayment of tax arisingtherefrom. Similarly, if a taxpayer ascertains that a liability was improperly taken into account in a prior taxable year,the taxpayer should, if within the period of limitation, file an amended return and pay any additional tax due." Seediscussion at P 2.02[2][f] regarding matching and the clear reflection of income requirement. See also Treas. Reg. §1.461-1(a)(2)(iii), pointing out that the above general rule is subject to the provisions of any Code section requiring aliability to be taken into account in a taxable year later than the taxable year provided in this regulation.

n159.1 See, e.g., Chernin v. United States, 149 F3d 805 (8th Cir. 1998). Determining whether this three-partall-events test has been satisfied is a question of law, which may be reviewed de novo by the courts. ChallengePublications, Inc. v. Comm'r, 845 F2d 1541 (9th Cir. 1988); Gold Coast Hotel & Casino v. United States, 158 F3d 484(9th Cir. 1998).

n159.2 See Ford Motor Co., 102 TC 87 (1994), aff'd, 71 F3d 209 (6th Cir. 1995), where the court denied adeduction on the basis of the clear reflection of income requirement, even though the deduction otherwise compliedwith the then-applicable all events test.

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n159.3 See, e.g., Exxon Mobil Corp., 114 TC 293 (2000), where the court stated: "The all-events test also appliesunder section 1012 to the accrual into the tax basis of capital assets of estimated future capital costs."

n160 Treas. Reg. § 1.461-1(a)(2)(i). Of course, the amount is deductible only if it is an otherwise deductibleexpense. If the liability results in the creation of an asset with a life substantially beyond the close of the year, theamount should be capitalized (or otherwise deferred) and amortized, depreciated, or expensed over the appropriateperiod to which it relates in accordance with applicable rules governing, e.g., cost recovery and depreciation. See, e.g.,Section 461(c) regarding taxes; Shelby Salesbook Co. v. United States, 104 F. Supp. 237 (ND Ohio 1952); OhmerRegister Co. v. Comm'r, 131 F2d 682 (6th Cir. 1942), regarding sales commissions.

n161 See, e.g., Harrold v. Comm'r, 192 F2d 1002 (4th Cir. 1951) (taxpayer entitled to deduction for miningreclamation costs in year of mining rather than in subsequent year when actual reclamation would occur); CrescentWharf & Warehouse Co. v. Comm'r, 518 F2d 772 (9th Cir. 1975) (taxpayer permitted to deduct uncontested liabilityunder workers' compensation law even though medical service would not be provided to employee until a later year);Pacific Grape Prods. Co. v. Comm'r, 219 F2d 862 (9th Cir. 1955) (taxpayer permitted to deduct in current yearanticipated costs of labeling, packaging, and shipping goods already sold); Ohio River Collieries Co., 77 TC 1369(1981) (strip miner allowed deduction for estimated costs of required reclamation work prior to time such workperformed).

n162 As an alternative to this prospective only or so-called cut-off approach, the taxpayer could elect to complywith the law by a change in accounting method, effective as of either (1) July 19, 1984 or (2) the first day of the taxableyear that included July 19, 1984. See Temp. Reg. § 1.461-3T, which was redesignated as Treas. Reg. § 1.461-7Tby thefinal economic performance regulations, effective April 10, 1992.

n162.1 See Ford Motor Co., 102 TC 87 (1994), aff'd, 71 F3d 209 (6th Cir. 1995), where the court denied adeduction that satisfied the then-applicable two-pronged all events test on the basis that the clear reflection of incomestandard allowed the Commissioner to achieve a result somewhat comparable to the result that would have beenachieved under the economic performance rules notwithstanding that those rules were not then in effect and were onlyto be applied prospectively.

n163 See infra P 4.04[1]-P 4.04[3].

n163.1 Of course, as a general rule, the fixed liability prong may be satisfied prior to, and independently of, thetime when an invoice is received. See, e.g., Golden Gate Litho, TCM , TC Memo. 1998-184 (1998), where the courtrecognized that it was an error to exclude from deductible expenses amounts that may have accrued, even though thetaxpayer had not yet been invoiced.

n164 United States v. Hughes Properties, Inc., 476 US 593 (1986). See Fong Venture Capital Corp., 53 TCM 647,TC Memo. 1987-208 (1987), where the court denied a deduction for interest paid on an asserted liability for a personalguarantee provided by an individual, because the amount to be paid for the guarantee was payable only at the "financialconvenience" of the obligor. This case involved the issue of whether an asserted obligation was, in fact, a validindebtedness. See also Hitachi Sales Corp., 64 TCM 634, TC Memo. 1992-504 (1992), where the court denied adeduction for liabilities to be incurred in the future, because such liabilities were not fixed within the year of deduction.

n164.1 See, e.g., Rev. Rul. 98-39, 1998-2 CB 198, where the IRS recognized that as a general rule, in a situationwhere one taxpayer is accruing a liability to pay another taxpayer, the event that establishes the fixed fact of liabilityunder the all events test for deductions is the same fact that establishes the fixed right to receive income under the allevents test for income.

n165 The Baltimore Transfer Co., 8 TC 1 (1947), acq. 1947-2 CB 1.

n165.1 See, e.g., Gold Coast Hotel & Casino v. United States, 158 F3d 484 (9th Cir. 1998), where the court

Page 30Federal Tax Accounting P 4.04

permitted a taxpayer to deduct its liability to customers for prizes once the customer had become entitled to a prize,even though there was a possibility that not all of the customers entitled to prizes would actually claim their prizes. Thecourt pointed out that all that was necessary to satisfy the all-events test was that there be a "reasonable expectancy" ofthe taxpayer's obligation being paid for with cash or its equivalent. See also Newhouse Broad. Corp., 80 TCM 178, TCMemo. 2000-244 (2000), where an issue arose as to whether a publisher had a fixed obligation to authors for royaltieson books sold, in circumstances where the publisher retained a portion of the royalty to take into account the probabilitythat some of the sold books might be returned. The court found that the retained portion of the royalty was merely asecurity arrangement protecting the publisher against the possibility that a circumstance would arise in the future thatwould relieve the taxpayer of its otherwise existing and fixed obligation to pay the royalty. However, as the courtexplained, that possibility was in the nature of a condition subsequent, and it did not prevent accrual and deduction ofthe full amount owed to the authors.

n165.2 See, e.g., Restore Inc., 74 TCM 1475, TC Memo. 1997-571 (1997), aff'd without opinion, 174 F3d 203(11th Cir. 1999), where the taxpayer was obligated to pay certain royalties under its written agreements, but had reachedan understanding with the other party that such amounts would not be treated as owed unless and until the taxpayer hadthe financial ability to pay such amounts. As the court stated in Newhouse Broad. Corp., 80 TCM 178, TC Memo.2000-244 (2000), citing various statements by other courts, the practical interpretation of a contract by the parties to itfor any extended period of time during which it is not in controversy is of great, if not controlling, influence; the mostreliable indicator of what the contracting parties meant is what they did; and there is no surer way to find out what theparties intended in their contract than to see how they have acted pursuant to it. Of course, in order to rely on anunderstanding of the parties or an intent that differs from the express provisions of the pertinent agreements, thetaxpayer must be able to demonstrate that the parties to the agreement were aware of and agreed to such anunderstanding at the time the written agreements were executed. See Michaelis Nursery, Inc., 69 TCM 2300 (1995),where the taxpayer's attempt to characterize certain advance payments as nontaxable deposits was rejected by the courtbecause of the taxpayer's inability to show that its routine practice of returning such amounts at the request of customerswas known to its customers at the time they entered into the agreements, and the agreements in question provided noobligation on the taxpayer to return any advance payment, assuming it fulfilled its other contractual responsibilities. Seealso ABC Beverage Corp. v. United States, 577 F. Supp. 2d 935 (WD Mich. 2008), where, in denying a motion forsummary judgment, the court concluded that a lessee's obligation to acquire leased property became fixed according tothe terms of the applicable lease agreement six months after the lessee gave notice of its intent to purchase, the courtconcluding that both the lessor and lessee became bound to the sale at that time in the absence of evidence to thecontrary; Hopkins Partners, TCM , TC Memo. 2009-107 (2009), where the Tax Court reiterated the general rule that, indetermining the intent of the parties to an agreement, the court looks to the express terms to the applicable documentand also to the surrounding circumstances, including how the parties to the agreement treated any payments made andreceived under the agreement, the question in this case being whether particular payments for capital improvementswere appropriately deducted as rent, the capital improvement being made in lieu of the otherwise required payment ofrent. Similarly, in Volvo Cars of N. Am. LLC v. United States, 571 F3d 373 (4th Cir. 2009), the court stated that,because of applicable local law governing the interpretation of contracts, the court not only must consider the applicablecannons of contract interpretation, but also must consider the parties' "course of performance" and the relevant"commercial context" in determining the meaning of, and the intention of the parties with respect to, the particularcontract before the court, in this case a contract that pertained to the manner in which certain inventory had beentransferred.

n165.3 Exxon Mobil Corp., 114 TC No. 20 (2000).

n165.4 See, e.g., Treas. Reg. § 1.451-5(c)(1)(ii), permitting the estimated cost of inventory to be taken into accountby the seller in determining the amount of income attributable to certain advance payments for the sale of goods.

n165.5 See, e.g., Tutor-Saliba Corp., 115 TC 1 (2000), where the court determined that certain disputed amountswere required to be taken into account as part of the total contract price in applying the percentage of completionmethod of accounting for long-term contracts.

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n165.6 See discussion in Charles Schwab Corp., 122 TC 191 (2004), supplemented by 123 TC 306 (2004), aff'dper curiam, 495 F3d 1115, 2007-2 USTC P 50,597 (9th Cir. 2007).

n165.7 Charles Schwab Corp., 122 TC 191 (2004), supplemented by 123 TC 306 (2004), aff'd per curiam, 495 F3d1115, 2007-2 USTC P 50,597 (9th Cir. 2007).

n165.8 See Ronald Moran Cadillac, Inc. v. United States, 385 F3d 1230 (9th Cir. 2004), where the court discussedthe deferral of an otherwise accrued liability by reason of Section 267, because the obligee was related to the obligor,this Section taking precedence over the normal accrual method rules.

n166 See discussion infra P 4.04[1][a]-P 4.04[1][c].

n166.1 For an interesting application of the requirement of a fixed liability, see Convergent Technologies, Inc., 70TCM 87, TC Memo. 1995-320 (1995), where an issue involved the character and time for recognizing the cost to theseller of issuing stock in exchange for warrants that had been issued to purchasers in order to induce them to purchasethe company's products. The court held that the cost to the taxpayer of issuing the warrants, which cost was representedby the difference between the value of the seller's stock at the time the warrants were issued to the purchasers and thevalue of that stock at the time the warrants were exercised, became fixed at the time the warrants became exercisable.However, the deduction attributable to the cost of the warrants, which the court classified as a sales discount or salesallowance, was not determinable with reasonable accuracy until the time the warrants were actually exercised.

n167 Compare Comm'r v. Champion Spark Plug Co., 266 F2d 347 (6th Cir. 1959), where the obligation of thecompany to pay an annuity was fixed upon the Board's action, with Comm'r v. H.B. Ives Co., 297 F2d 229 (2d Cir.1961), cert. denied, 370 US 904 (1962), where the Board's initial action, which merely authorized the company topurchase an annuity, did not itself result in a fixed liability.

n168 See, e.g., William J. Ostheimer, 1 BTA 18 (1924), (deductions for existing obligation to restore leasedchattels denied in year prior to year in which actual expenses incurred in restoring such chattels); Amalgamated Hous.Corp. 37 BTA 817 (1938), aff'd per curiam, 108 F2d 1010 (2d Cir. 1940) (deductions with respect to existing obligationto renovate the real property denied until those required to perform the renovation actually rendered services); Spencer,White & Prentis, Inc. v. Comm'r, 144 F2d 45 (2d Cir. 1944), cert. denied, 323 US 780 (1944) (deduction was deniedwith respect to obligation to restore property damaged during course of taxpayer's work until expense was incurred bythose who were to make restorations); National Bread Wrapping Mach. Co., 30 TC 550 (1958)(deductions denied forobligation to furnish installation services with respect to property sold until such services were performed).

n169 See Harrold v. Comm'r, 192 F2d 1002 (4th Cir. 1951); Denise Coal Co. v. Comm'r, 271 F2d 930 (3d Cir.1959); Ohio River Collieries Co., 77 TC 1369 (1981).

n169.1 See, e.g., Exxon Mobil Corp., 114 TC No. 20 (2000), where the court allowed certain expenses butdisallowed others, depending on the certainty, clarity, and lack of ambiguity in relevant state law and agreements withstate agencies.

n170 Gillis v. United States, 402 F2d 501 (5th Cir. 1968).

n171 Id. at 508. This statement by the court also illustrates the practical importance to the court of matchinginterrelated items in the same year as well as the need for the liability to be certain and not contingent.

n172 Id. at 507.

n172.1 Chrysler Corp., 80 TCM 334, TC Memo. 2000-283 (2000), aff'd, 436 F3d 644 (6th Cir. 2006). In affirmingthe Tax Court, the Court of Appeals concluded, among other things, that a liability that is fixed by a statute does not, bythat fact itself, satisfy the first (or fixed liability) prong of the all-events test. Rather, the court concluded, that prong of

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the test is satisfied if the statute has "the effect of irrevocably setting aside a specific amount, as if it were to be put intoan escrow account, by the close of the tax year and to be paid at a future date." Id. at 650. One can only assume that theCourt of Appeals would equate its "setting aside as if placed in an escrow account" requirement with a taxpayer'srecognition of the liability in its financial statements. If this were not the case, the conclusion stated by the court couldcause a major disruption for businesses that routinely recognize liabilities on their books, but, of course, do not,literally, set aside funds or put funds into an escrow account in order to satisfy their liabilities. The Court of Appealsalso concluded that it was difficult to distinguish United States v. Hughes Property Inc., 476 US 593 (1986), fromUnited States v. General Dynamics Corp., 481 US 239 (1987), cases that might be thought by others easilydistinguished on the basis of their facts. For instance, all conditions precedent to the liability of the taxpayer in HughesProperties had been satisfied, the identity of the person to whom payment would be made being regarded as irrelevant.However, all conditions precedent had not been satisfied in General Dynamics, because, until claims were filed, onecould not assume that all possible claims would be filed, i.e., that the filing of a claim was only a ministerial act. Thedistinguishing principle arising from the two cases may be that deductions should not be allowed for liabilities orexpenses that might never be incurred (the Court in Hughes Properties finding that such a possibility was remote),while the circumstances in General Dynamics indicated the contrary. While persons may disagree with the findings offact in General Dynamics, the facts, once found, do seem to distinguish the two cases.

n172.2 See, e.g., Exxon Mobil Corp., 114 TC No. 20 (2000), where the court stated: "The first prong of theall-events test looks only to whether the taxpayer's fact of liability for the costs in question has been established. Thistest may be satisfied even if it is not known when or to whom costs will be paid."

n173 Washington Post Co. v. United States, 405 F2d 1279 (Ct. Cl. 1969).

n174 Id. at 1283.

n175 Id. See also Lukens Steel Co. v. Comm'r, 442 F2d 1131 (3d Cir. 1971); Keebey's Inc. v. Paschal, 188 F2d113 (8th Cir. 1951); Clark v. Woodward Constr. Co., 179 F2d 176 (10th Cir. 1950); United Control Corp., 38 TC 957(1962), acq. 1966-1 CB 3. But see Rev. Rul. 72-34, 1972-1 CB 132, and Rev. Rul. 76-345, 1976-2 CB 134, where theIRS announced that it would not follow Lukens Steel and Washington Post, respectively. These IRS rulings should beof less concern today in light of the Supreme Court's opinion in United States v. Hughes Properties, Inc., 476 US 593(1986). Yet, examining agents still sometimes disallow deductions on the basis of these revenue rulings. Suchdisallowances are usually inconsistent with controlling cases and should not be sustained.

n176 United States v. Hughes Properties, Inc., 86-1 USTC P 9440 (1986).

n176.1 In Rev. Rul. 2011-29, IRB , the IRS published its acceptance of the principle of Washington Post andHughes Properties that a taxpayer may have a fixed liability by the end of a year for bonuses payable in the next year toa group of employees, even though the identity of the particular employees to which the bonuses will be paid will not beknown until after the end of the taxable year. In the particular bonus program that was the subject of the ruling, thebonuses were for services performed during a particular year; the minimum aggregate amount of the bonuses payable tothe employees as a group was fixed by reason of a binding formula or resolution adopted by the taxpayer's Board ofDirectors or Compensation Committee before the end of the year; and although the bonuses would be payable only toemployees who remained employed on the date the bonuses would be paid, any amount attributable to departedemployees would not be returned to the taxpayer but would be reallocated to the then employed employees who wereotherwise eligible for the bonus.

n177 Iowa S. Utils. Co. v. United States, 87-1 USTC P 9217 (Cl. Ct. 1987), aff'd, 841 F2d 1108 (Fed. Cir. 1988).

n178 See Roanoke Gas Co. v. United States, 92-2 USTC P 50,496 (4th Cir. 1992) Southwestern Energy Co., 100TC 500 (1993), for this same point; but see Illinois Power Co. v. Comm'r, 792 F2d 683 (7th Cir. 1986), where theoriginal receipt of excess rates was held not to constitute income because the subsequent refunds of the excess rates

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would be in the form of a credit on the bills of particular customers, interest would be paid, and the utility wouldfunction more in the nature of a custodian of the funds than in some other capacity.

n179 Helvering v. Russian Fin. & Constr. Corp., 77 F2d 324 (2d Cir. 1935).

n180 Id. at 327.

n181 Id.

n182 Id. In contrast, where the liability itself is contingent on the taxpayer's ability to pay, the all-events test maynot be satisfied until that condition has been met. See, e.g., Putoma Corp. v. Comm'r, 601 F2d 734 (5th Cir. 1979);Restore, Inc., 74 TCM 1475, TC Memo. 1997-571 (1997), aff'd without opinion, 174 F3d 203 (11th Cir. 1999); each ofwhich involves circumstances in which the taxpayer's obligation was contingent on a determination that it had theability to pay the amounts at issue.

n183 See also United States v. Hughes Properties, Inc., 476 US 593 (1986) (fact that liability could beextinguished by certain actions of taxpayer, such as its termination of business, bankruptcy, or the like, does not preventaccrual); Lawyers' Title Guar. Fund v. United States, 508 F2d 1 (5th Cir. 1975) (commissions accrued even though theycould be reduced by subsequent events before actual payment); Consolidated Foods Corp., 66 TC 436 (1976) (rentaccrued even though it could be reduced or eliminated by subsequent events); Geo. K. Herman Chevrolet. Inc., 39 TC846, 853 (1963) ("An otherwise proper deduction should not be disallowed in the year it was paid or incurred becauseof the existence of a possibility that at some future date the taxpayer might receive a reimbursement therefor"); TheElectric Tachometer Corp., 37 TC 158 (1961) (moving expenses accrued, although they could be reduced bysubsequent reimbursement); Alleghany Corp., 28 TC 298 (1957), acq. 1957-2 CB 3 (possibility of reimbursement doesnot preclude deduction); Midwest Motor Express, Inc., 27 TC 167 (1956), aff'd on other grounds, 251 F2d 405 (8thCir.), cert. denied, 358 US 875 (1958) (retrospective adjustment deductible in year prior to actual assessment); BurnhamCorp., 90 TC 953 (1988), aff'd, 878 F2d 86 (2d Cir. 1989) (liability fixed even though payments would terminate upondeath of party to whom liability owed); Newhouse Broad. Corp., 80 TCM 178, TC Memo. 2000-244 (2000) (liability forauthors' royalties fixed at time of sale even though the amount of that liability might thereafter be reduced by returns ofpreviously sold books).

n184 See, e.g., Scott Paper Co., 74 TC 137 (1980); Tandy Corp. v. United States, 626 F2d 1186 (5th Cir. 1980);Rev. Rul. 74-127, 1974-1 CB 47.

n185 See, e.g., Scott Paper Co., 74 TC 137 (1980); Tandy Corp. v. United States, 626 F2d 1186 (5th Cir. 1980);Rev. Rul. 74-127, 1974-1 CB 47.

n186 United States v. Hughes Properties, Inc., 476 US 593 (1986).

n186.1 Southwestern Energy Co., 100 TC 500 (1993).

n187 United States v. Texas Mexican Ry., 263 F2d 31, 35 (5th Cir. 1959).

n188 Eastman Kodak Co. v. United States, 534 F2d 252 (Ct. Cl. 1976). However, consider the impact of theeconomic performance test. If economic performance were deemed to occur only as payments are made, the deductionmight be denied until the year of payment unless an exception to the economic performance test were applicable. Seediscussion infra P 4.04[3].

n188.1 Although the IRS initially disagreed with the conclusion of the court in Eastman Kodak, the IRS ultimatelyaccepted the court's conclusion in Rev. Rul. 96-51, 1996-2 CB 36, revoked its prior position, and ruled that an accrualmethod employer may deduct applicable payroll taxes imposed on year-end wages that are properly accrued in one yearbut are paid in the next year, provided that the employer satisfies the requirements of the recurring item exception to the

Page 34Federal Tax Accounting P 4.04

economic performance rules with respect to those taxes. Thereafter, in Rev. Proc. 2008-25, 2008- IRB , the IRSprovided a safe harbor method of determining deductions for certain payroll taxes on compensation, including bonusesand vacation pay, and provided procedures for taxpayer to obtain the automatic consent of the Commissioner to changeto the safe harbor method.

n189 Id. at 260, n.P 12. See also United States v. Hughes Properties, Inc., 476 US 593 (1986); Burlington N. R.R.,82 TC 143 (1984).

n190 See, e.g., Hollingsworth v. United States, 568 F2d 192 (Ct. Cl. 1977), where taxpayer asserted that becauseincome was accrued for federal tax purposes, he should receive a deduction for the state tax that would be attributable toand payable on account of that accrued income, despite the fact that he was on a cash method for state tax purposes andwas in the process of contesting a proposed change to an accrual method for state tax purposes. The taxpayer arguedthat the contest with the state was over when the income accrued for federal tax purposes would be reported to the state,not if that income would be subject to tax. The court nevertheless held that the state tax was contingent and notdeductible until the contest was resolved. Compare Metro Leasing & Dev. Corp., 119 TC 8 (2002), where the courtrefused to allow a taxpayer to recognize income on an installment sales basis but to reduce accumulated taxable income(for purposes of the accumulated earnings tax) as if the gain had been recognized on an accrual basis. See discussioninfra P 4.04[1][c] regarding the impact on accrual of an existing dispute or contest.

n190.1 See, e.g., Black Gold Energy Corp., 99 TC 482 (1992), where a guarantor of another's debt sought to accruea deduction for the resulting loss in the year in which its liability as a guarantor arose, but this deduction was deniedbecause Treas. Reg. § 1.166-9(a) expressly precluded such a deduction until the year in which payment of theguaranteed indebtedness was made.

n191 See, e.g., United States v. Hughes Properties, Inc., 476 US 593 (1986); United States v. General DynamicsCorp., 481 US 239 (1987); Fourth Fin. Corp., 49 TCM 1485, TC Memo. 1985-232 (1985). See also Exxon Mobil Corp.,114 TC No. 20 (2000), where the court stated that a liability can be fixed even though there are procedural or ministerialsteps that still have to occur before payment; Tech. Adv. Mem. 9143083 (Aug. 1, 1991), where in the course ofdetermining whether a taxpayer had obtained a fixed right to receive income (i.e., reimbursements for certain costsincurred), the National Office concluded that the filing of the forms requesting reimbursement was not a conditionprecedent that would prevent accrual because the filing of the forms was ministerial in nature and the likelihood of anychallenge to the requests was extremely remote and speculative. Presumably, a similar analysis would be made by theIRS for items of expense. Nevertheless, in Tech. Adv. Mem. 9416004 (Dec. 23, 1993), the IRS National Office (NationalOffice) followed the literal language of an agreement between a taxpayer and its customers in denying the existence of afixed obligation to pay prior to the time when the requisite forms and evidence of advertising were submitted, but theNational Office also acknowledged that such contractual terms could be overcome by showing that state law wouldoperate to override or ignore that particular language in the agreement.

n192 Simplified Tax Records, Inc., 41 TC 75 (1963).

n193 See United States v. General Dynamics Corp., 481 US 239 (1987), estimate of future liability, no matter howaccurate, is not the equivalent of a presently fixed liability; Bell Elec. Co., 45 TC 158 (1965), acq. 1966-2 CB 4, wherededuction was denied for the estimated future cost of servicing appliances sold under warranty agreements; JuniataFarmers Coop. Ass'n, 43 TC 836 (1965), where deduction was denied for estimated spoilage and damage to storedgrain. See also Challenge Publications, Inc. v. Comm'r, 845 F2d 1541 (9th Cir. 1988); Dana Distribs., Inc., 56 TCM569, TC Memo. 1988-514 (1988), aff'd, 874 F2d 120 (2d Cir. 1989). Challenge involved a magazine publishercontractually obligated to credit its customers for unsold copies of its magazines. The publisher was denied a deductionfrom income (or a reduction in income) for its estimate of unsold copies. The court found that the taxpayer was notunder a fixed obligation to make refunds until it received evidence of the unsold copies from its customers. DanaDistributorsinvolved a beverage distributor who charged a container deposit on all beverages sold in nonrefillablecontainers. The taxpayer argued that if the deposit were treated as income, the taxpayer should be entitled to an

Page 35Federal Tax Accounting P 4.04

offsetting deduction for its liability to pay refunds when the containers were returned. The court disagreed, pointing outthat no liability for any such refund would become fixed until the container was returned by a customer. See generallyStanger, Vander Kam & Polifka, "Prepaid Income and Estimated Expenses; Financial Accounting Versus TaxAccounting Dichotomy," 33 Tax Law. 403 (1980).

n193.1 See, e.g., United States v. Hughes Properties, Inc., 476 US 593 (1986); United States v. General DynamicsCorp., 481 US 239 (1987). Although the above-stated rationale may easily distinguish the results in these two cases, notall may agree. See, e.g., Chrysler Corp. v. Commissioner, 436 F3d 644 (6th Cir. 2006), where the court expressedsympathy for the observation of Justice O'Connor in her dissent in General Dynamics that its circumstances differedlittle from those in Hughes Properties.

n193.2 See, e.g., TransAmerica Corp. v. United States, 999 F2d 1361 (9th Cir. 1993), where a taxpayer waspermitted to take into account in determining amounts subject to depreciation under the income forecast method theestimated amount of so-called participations and residuals. The court allowed such amounts to be taken into account,noting that there was no possibility under the income forecast method of allowing deductions or depreciation onliabilities that might never occur. Although this principle might not be applicable to many circumstances, taxpayers andtax practitioners should always remember the possibility of its application. But consider Prop. Treas. Reg. § , whichdoes not follow the approach used in TransAmerica Corp.

n193.3 See, e.g., Gold Coast Hotel & Casino v. United States, 158 F3d 484 (9th Cir. 1998), where a taxpayer,which offered prizes to customers who earned a sufficient number of points in a so-called slot club, was allowed todeduct the amounts owed even though it could reasonably be anticipated that not all customers entitled to prizes wouldactually seek to obtain them; Flamingo Resort, Inc. v. United States, 664 F2d 1387 (9th Cir. 1982), applying anessentially similar proposition to the all-events test applicable to items of income.

n193.4 See Schlumberger Tech. Corp. v. United States, 195 F3d 216 (5th Cir. 1999).

n194 See, e.g., Challenge Publications, Inc. v. Comm'r, 845 F2d 1541 (9th Cir. 1988), where the taxpayer wasdenied the opportunity to reduce income by amounts estimated to be uncollectible, but the taxpayer based its argumentto the court on an asserted right to deduct the anticipated uncollectibles rather than on a right to exclude the amountsfrom income. See also discussion of items of doubtful collectibility supra P 4.03[2].

n194.1 Spitzer Columbus, Inc., 70 TCM 448, TC Memo. 1995-397 (1995).

n194.2 United States v. General Dynamics Corp., 481 US 239 (1987).

n194.3 See Tech. Adv. Mems. 9143083 (Aug. 1, 1991), 9416004 (Dec. 23, 1993).

n194.4 Jeffrey M. Bigler, TCM , TC Memo. 2008-133 (2008).

n195 R. Wixon, Accountants' Handbook 1.17 (4th ed. 1965).

n196 United States v. Anderson, 269 US 422, 440 (1926).

n197 Ohmer Register Co. v. Comm'r, 131 F2d 682 (6th Cir. 1942). See also Shelby Salesbook Co. v. United States,104 F. Supp. 237 (ND Ohio 1952).

n198 The Ohmer court stated:

To divide the sales transactions here involved so as to treat them upon an accrual basis with respect to income andupon a cash basis with respect to expense in commissions in making sales from which the income was derived would be. . . objectionable. . . . [T]he net income . . . could not have been correctly determined upon the accrual basis, withoutdeducting the commission expense from gross income. Id. at 686. See also Pacific Grape Prods. Co. v. Comm'r, 219

Page 36Federal Tax Accounting P 4.04

F2d 862 (9th Cir. 1955) (seller of food products permitted to deduct in year of sale the costs of packaging and shippingthe products sold, even though such activities had not yet occurred); Hilinski v. Comm'r, 237 F2d 703 (6th Cir. 1956)(accrual of estimated amount of liability not to be denied even though certain necessary performance had not yetoccurred); Consolidated Edison Co. of N.Y. v. United States, 135 F. Supp. 881, 884 (Ct. Cl. 1955), cert. denied, 351 US909 (1956): "Under the accrual system of accounting revenues are accrued as nearly as practicable to the period earnedand expenses, which include taxes, are accrued in the period and against the revenues they helped to produce." Theparticular issue in Consolidated Edison was whether an asserted liability was deductible in the year of payment, if latercontested. The Court of Claims answered in the affirmative. Later, because of a conflict among jurisdictions, theSupreme Court considered the issue in a related case and held to the contrary. United States v. Consolidated Edison Co.of N.Y., 366 US 380 (1961). In response, Congress overturned the result of the decision of the Supreme Court byenacting Section 461(f). See discussion infra P 4.04[1][c][i].

n199 Dravo Corp. v. United states, 348 F2d 542 (Ct. Cl. 1965). See also Helvering v. Russian Fin. & Constr.Corp., 77 F2d 324, 328 (2d Cir. 1935), where the court stated:

The fundamental requirement is that the return reflects true income, and expenses must be set off against theincome to which they are attributable. United States v. Anderson, supra; Miller & Vidor Lumber Co. v. Comm'r, 39F.(2d) 890, 892 (C.C.A.5). In the latter case, the court said: "We think these cases and the regulations clearly establishthe rule that, as to taxpayers making their returns on the accrual basis, deductions attributable to the business of aparticular year must be applied against the income they help to create from the business of that year, and not against thatof a subsequent year in which payment was made."In Beacon Publishing Co. v. Comm'r, 218 F2d 697, 699 (10th Cir. 1955), the court stated: "An important feature of theaccrual system is that income shall be reported at such a time that it will, so far as possible, be offset by expendituresincident to earning it, rather than expenditures related to earning other income."

n200 Dravo Corp. v. United States, 348 F2d 542, 544 (Ct. Cl. 1965).

n201 See P 2.02[2] generally and P 2.02[2][f] for discussions of the clear reflection of income standard and theeffect on it of any particular matching of related items of income and expense.

n201.1 See, e.g., Fidelity Assocs., Inc., 63 TCM 2327, TC Memo. 1992-142 (1992), where the Tax Court allowedthe deduction of certain selling commissions in the year in which the all events test was satisfied notwithstanding theCommissioner's assertion that the allowance of such deductions created a mismatch between related items of incomeand expense and thereby caused the taxpayer's method to fail to reflect income clearly.

n202 See, e.g., Brown v. Helvering, 291 US 193 (1934) (no deduction for commission refunds due insurancecompanies by taxpayer-agent even though it was likely that a portion of commission income recognized in one yearwould be refunded in later years); Northwestern States Portland Cement Co. v. Huston, 126 F2d 196 (8th Cir. 1942);Readers' Publishing Corp. v. United States, 40 F2d 145 (Ct. Cl. 1930).

n202.1 Newhouse Broad. Corp., 80 TCM 178, TC Memo. 2000-244 (2000).

n203 See Gunn, "Matching of Costs and Revenues As a Goal of Tax Accounting," 4 Va. Tax Rev. 1 (1984).

n203.1 Compare Rameau A. Johnson v. Comm'r, 184 F3d 786 (8th Cir. 1999), where the court found therelationship between items of income and expense to be so close in the particular circumstances that the court allowedthe taxpayer to deduct the expenses in the same year that the taxpayer was required to recognize the related income,notwithstanding the fact that economic performance had not then occurred with respect to those expenses, with ExxonMobil Corp., 114 TC No. 20 (2000), where the court stated that under the matching principle of federal income taxaccounting, expenses may be recognized only if they satisfy the all-events test, and that to allow an accrual of expensesthat do not satisfy the test to offset current income is not part of the matching principle. As these two cases and thediscussion in P 4.04[1][b] suggest, the Tax Court has been far more willing than various courts of appeals to adhere to

Page 37Federal Tax Accounting P 4.04

the technical importance of regulatory provisions without regard to the effects on matching. See, e.g., Toyota Town,Inc., 79 TCM 1457, TC Memo. 2000-40 (2000), where the Tax Court found that the taxpayer's method of taking intoaccount certain expenses on a basis that matching them more precisely to the corresponding income nevertheless failedto reflect income clearly, because that approach violated applicable regulations and conditions for use of the particularmethod of recognizing income used by the taxpayer. In reaching this conclusion, the court stated that the matching ofinterrelated items of income and expense does not necessarily result in a clear reflection of income for tax purposes,particularly where the matching in question violates the requirements of applicable regulations, revenue rulings, orrevenue procedures providing for use of a particular method of recognizing income. Indeed, in affirming Toyota Town,the Court of Appeals for the Ninth Circuit noted that the opinion in Toyota Town was not inconsistent with the opinionof the Court of Appeals for the Eighth Circuit in Rameau A. Johnson, because the court in Rameau A. Johnson was notaddressing a method of accounting authorized by the Commissioner in his published rulings or procedures, butconditioned on certain requirements being satisfied. Bob Wondries Motors, Inc. v. Comm'r, 88 AFTR2d 2001-6489, 268F3d 1156 (9th Cir. 2001), aff'g Toyota Town, Inc., 79 TCM 1457, TC Memo. 2000-40 (2000).

n204 Dixie Pine Prods. Co. v. Comm'r, 320 US 516 (1944); Chernin v. United States, 149 F3d 805 (8th Cir. 1998).The rationale of Dixie Pine Products has also been applied in the context of determining a deduction for federal incometaxes for purposes of determining a taxpayer's liability for tax on unreasonably accumulated earnings. See MetroLeasing and Development Corp., 119 TC 8 (2002). See also David Martin, 98 TCM 338, TC Memo. 2009-234 (2009),where the court concluded that a corporation's challenge to an asserted employment tax liability on the basis that theindividual in question was not an employee of the corporation amounted to a contest that prevented accrual in the yearto which the asserted liability related, the court stating the general rule that a "liability is not fixed if a taxpayer disputessuch liability."

n205 Treas. Reg. § 1.461-2(b)(2).

n206 See, e.g., Hitachi Sales Corp., 64 TCM 634, TC Memo. 1992-504 (1992), where deduction of a purportedliability to terminated employees was denied because, from all the facts and circumstances, there had been no clearadmission of liability by the taxpayer; H.E. Boecking, Jr., 66 TCM 1148, TC Memo. 1993-497 (1993), where ataxpayer's attempted reduction in income received on account of a corporate liquidation--to take into account thetaxpayer's transferee liability for certain proposed corporate income tax deficiencies--was denied, because, among otherthings, the corporation had consistently reported in a note to its financial statements that it intended vigorously todefend against the proposed income tax deficiencies.

n207 Dravo Corp. v. United States, 348 F2d 542, 46 n.1 (Ct. Cl. 1965). In Dravo, the court held that the merefiling of return showing a specified amount of tax is not a contest of a later asserted and accepted deficiency. See alsoLutz v. Comm'r, 396 F2d 412, 415 (9th Cir. 1968), where the Court of Appeals for the Ninth Circuit held: "[A]s theCourt of Claims indicated in Dravo, adoption of a narrow interpretation of "contest" within the meaning of Dixie PineProducts will lead to a more accurate and equitable determination of net income for the purposes of taxation."

n208 Lutz v. Comm'r, 396 F2d 412 (9th Cir. 1968); See Harry Gordon, 63 TC 501 (1975), aff'd in part and rev'd inpart on other issues, 572 F2d 193 (9th Cir. 1977), cert. denied, 435 US 924 (1978); Hollingsworth v. United States, 568F2d 192 (Ct. Cl. 1977) (because dispute must be bona fide, fraudulent acts designed to avoid liability will not bedeemed a contest of that liability assuming such fraud could be proved). See also Bear Film Co., 18 TC 354 (1952), acq.1955-1 CB 3, aff'd on other grounds, 219 F2d 231 (9th Cir. 1955), acq. 1955-1 CB 3, aff'd on other grounds, 219 F2d231 (9th Cir. 1955) (capricious failure to pay liability is not a contest).

n209 Woodmont Terrace, Inc. v. United States, 261 F. Supp. 789 (MD Tenn. 1966).

n210 See Fox v. Comm'r, 874 F2d 560 (8th Cir. 1989), aff'g 53 TCM 651, TC Memo. 1987-209 (1987), where thecourt concluded that the taxpayer's position in certain litigation (involving the taxpayer's denial of liability under certainobligations), when taken as a whole and in concert with the relevant documents and other applicable testimony, caused

Page 38Federal Tax Accounting P 4.04

the taxpayer to be treated as contesting any and all possible obligations that were inherently associated with theobligations he explicitly contested ; Warnock Davies, 101 TC 282 (1993), where the court found the taxpayer's efforts toavoid certain asserted claims against it by transferring cash and the deed to his house, all in the context of a bankruptcyproceeding involving the taxpayer's employer, to amount to a contest; H.E. Boecking, Jr., 66 TCM 1148, TC Memo.1993-497 (1993), where the failure of a corporate taxpayer to accept certain proposed income tax deficiencies,combined with notes to its financial statements setting forth its intent vigorously to defend against such deficiencies,caused the court to find that a contest existed.

n210.1 Reading & Bates Corp. v. United States, 81 AFTR2d 98-1126 (Fed. Cl. 1998).

n211 Woodmont Terrace, Inc. v. United States, 261 F. Supp. 789 (MD Tenn. 1966).

n212 Id. 793.

n213 Gillis v. United States, 402 F2d 501 (5th Cir. 1968).

n214 Id. at 509.

n215 Id. at 510.

n216 Id.

n216.1 Exxon Corp., 78 TCM 165, TC Memo. 1999-247 (1999).

n217 United States v. Consolidated Edison Co. of N.Y., 366 US 380 (1961).

n217.1 See, e.g., Chernin v. United States, 149 F3d 805 (8th Cir. 1998).

n217.2 Treas. Reg. § 1.461-2(c)(1)(i)(B).

n218 Although Section 461(f) was intended to alleviate the problems experienced by accrual method taxpayers,Treas. Reg. § 1.461-2(e) suggests that the section is also applicable to cash method taxpayers, because it states that theexistence of a contest must be the only factor preventing a deduction for the year of transfer or "in the case of an accrualmethod taxpayer, for an earlier taxable year. . . . This language suggests that the section covers taxpayers other thanthose on an accrual method. However, the section provides that the sole reason for the denial of the deduction must bethe existence of the contest. For a cash method taxpayer, existence of a contest does not prevent deduction if payment ismade to the person asserting the liability. (See discussion at P 3.04.) If a cash method taxpayer pays someone other thanthe person asserting the liability, then, arguably, the deduction should be denied for failing to pay the correct person, notbecause of the contest. However, that result seems unsound. A more principled analysis would permit the cash basistaxpayer to pay someone other than the person asserting the liability, albeit an appropriate entity, such as an escrowee ortrustee, and still obtain the deduction. In James W. Perkins, 92 TC 749 (1989), the Tax Court allowed interest paid on anasserted federal income tax deficiency to be deducted in the year of payment, noting the applicability of Section 461(f).See also Wallace Preble, 57 TCM 295, TC Memo. 1989-208 (1989) to the same effect ; and Sarah J. Burns, 94 TCM276, TC Memo. 2007-271 (2007), aff'd, F3d , 2009-1 USTC P 50,402 (9th Cir. 2009), where a taxpayer was required toinclude in income an amount actually received even though that amount was immediately turned over to a bankruptcycourt as a result of a voluntary decision made by the taxpayer in response to certain claims previously asserted againsther by a third party, the court recognizing the Commissioner's concession that to the extent the amount was included inthe income of this cash basis taxpayer, the taxpayer would be entitled to a deduction for the same amount under Section461(f).

n218.1 Warnock Davies, 101 TC No. 282 (1993).

n218.2 See also Continental Nut Co., 62 TC 771 (1974), where the court held to the contrary in a situation in

Page 39Federal Tax Accounting P 4.04

which a purported "sale" of property resulting from contested property taxes was found merely to create a lien on theproperty and not to amount to a transfer of ownership.

n219 Treas. Reg. § 1.461-2(c)(1)(ii).

n220 See, e.g., Poirier & McLane Corp., 547 F2d 161 (2d Cir. 1976), rev'g 63 TC 570 (1975), rev'g 63 TC 570(1975); Rosenthal v. United States, 86-2 USTC P 9776 (Ct. Cl. 1986).

n220.1 Treas. Reg. § 1.461-2(c)(1).

n220.2 Poirier & McLane Corp. v. Comm'r, 547 F2d 161 (2d Cir. 1976), cert. denied, 431 US 967 (1977).

n220.3 Varied Invs., Inc. v. United States, 31 F3d 651 (8th Cir. 1994); Chem Aero Inc. v. United States, 694 F2d196 (9th Cir. 1982).

n220.4 Chernin v. United States, 149 F3d 805 (8th Cir. 1998).

n220.5 Trinity Indus., Inc., 132 TC No. 2 (2009).

n221 For a discussion of the economic performance test, see infra P 4.04[3].

n221.1 Maxus Energy Corp. v. United States, 31 F3d 1135 (Fed. Cir. 1994).

n221.2 See Notice 2003-77, 2003-49 IRB 1182, and Rev. Proc. 2004-31, 2004-22 IRB 986, providing proceduresfor taxpayers to change their method of accounting for deducting under Section 461(f) amounts transferred to contestedliability trusts if their method of accounting is not in accord with these rules.

n221.3 See Treas. Reg. §§ 1.461-2(c), 1.461-2(e), 1.461-2(g), with § 1.461-2(g) providing the applicable effectivedates.

n221.4 Chernin v. United States, 149 F3d 805 (8th Cir. 1998).

n222 Treas. Reg. § 1.461-2(f) has been reserved by the Treasury for rules governing this issue as well as overallrules governing the treatment of money or property transferred to an escrowee, trustee, or a court.

n223 See, e.g., Comm'r v. Fifth Ave. Coach Lines, Inc., 281 F2d 556 (2d Cir. 1960), cert. denied, 366 US 964(1961); Maxus Energy Corp. v. United States, 31 F3d 1135 (Fed. Cir. 1994), where the court reiterated the rule that inthe case of a contested liability, the liability does not become fixed "until the contest has been finally resolved." See alsoDavid Martin, 98 TCM 338, TC Memo. 2009-234 (2009), where the court stated the general rule that a taxpayer "maynot claim a deduction for a contested tax liability before the year the contest is ended by compromise or settlement orthrough a final disposition.". See also discussion supra P 4.03[1][a][i].

n223.1 Volvo Cars of N. Am., Inc. v. United States, 97-2 USTC P 50,705 (MDNC 1997). But compare ExxonCorp., 78 TCM 165, TC Memo. 1997-247 (1999).

n223.2 See Maxus Energy Corp. v. United States, 31 F3d 1135 (Fed. Cir. 1994), where the governmentacknowledged this point, even though the settlement agreement itself was subject to court approval, and that approvaldid not occur until the succeeding taxable year.

n224 Treas. Reg. § 1.461-1(a)(2)(ii). The regulation provides the following example. Assume A renders services toB during the taxable year for which Acharges $10,000. B admits a liability to A for $6,000 but contests the remainder.According to the regulations, B may take into account only $6,000 as an expense for the taxable year in which theservices were rendered. See Denis H. Dieker, 90 TCM 329, TC Memo. 2005-225 (2005), where the court referred to this

Page 40Federal Tax Accounting P 4.04

example in allowing the taxpayer to deduct that portion of an asserted liability to which the taxpayer agreed. The courtconcluded that, even though the taxpayer denied its liability for the full amount asserted against it, the taxpayer didacknowledge its obligation for a minimum amount, and the court allowed its deduction of that minimum amount.

n225 Treas. Reg. § 1.461-1(a)(3). Although this regulation suggests the possibility that a taxpayer might shift somedeductible expense from one year to another on the basis of erroneous estimates, that possibility is limited by Treas.Reg. § 1.461-1(a)(3), which points out that each year's return must be complete and based on the facts andcircumstances of that year. A taxpayer may not take advantage in a subsequent year of his failure to claim a deductionin the earlier year if it was appropriate to claim the deduction in such earlier year. In other words, if errors were made incomputation of the amount because of a failure to consider all applicable facts and circumstances, the appropriateprocedure may be to file an amended return rather than merely correcting the amount of the deduction in the subsequentyear. Similarly, a taxpayer that has satisfied the first prong of the all-events test--that all events have occurred which fixthe fact of liability in a particular year--may not ignore that fact and treat the liability as having become fixed in adifferent year. Assuming that the other prongs of the all-events test are satisfied in a particular year, then the taxpayermust recognize a deduction in the first year in which the fact of liability becomes fixed. Failing to do so obligates thetaxpayer to file an amended return in order to claim the deduction in the appropriate year.

n226 See Burnham Corp., 90 TC 953 (1988), aff'd, 878 F2d 86 (2d Cir. 1989), aff'd, 878 F2d 86 (2d Cir. 1989).

n226.1 City of New York, 103 TC 481 (1994).

n226.2 But see Ford Motor Co., 102 TC 87 (1994), an opinion issued before the opinion in City of New York,where the court limited a deduction for amounts due under a structured settlement to amounts paid to purchase annuitiesto fund the ultimate liability, thereby achieving a result comparable to the imposition of a present value limitation on theamount of the deduction. It remains to be seen whether Ford Motor Co. will be affirmed on appeal.

n226.3 See, e.g., Interex, Inc., 83 TCM 1306, TC Memo. 2002-57 (2002), aff'd, 321 F3d 55 (1st Cir. 2003), wherethe court denied a taxpayer's deduction of $65,000 for professional fees in the year claimed on the basis that onlyinadequate evidence and a lack of contemporaneous documentation had been provided in support of the deduction. Thecourt concluded that the absence of contemporaneous documentation made it impossible for the amount at issue to havebeen determined with reasonable accuracy as of the end of the relevant taxable year.

n226.4 See P 9.06, main volume, which discusses whether a change in method of reporting constitutes a change inmethod of accounting or a change in underlying facts that does not amount to a change in method of accounting.

n226.5 See discussion supra P 4.03[1][b].

n226.6 See, e.g., Hilinski v. Comm'r, 237 F2d 703 (6th Cir. 1956), the court pointing out the established rule thatthe mere fact that an accrued liability is based on an estimate does not defeat deductibility, and no issue arises regardingthe use of an estimate unless the Commissioner asserts that the amount of the estimate is unreasonable.

n227 Treas. Reg. § 1.461-1(a)(2)(ii).

n228 But see discussion supra P 4.04[1][c] regarding contested liabilities.

n228.1 See ABC Beverage Corp. v. United States, 577 F. Supp. 2d 935 (WD Mich. 2008), where, in denying amotion for summary judgment, the court concluded that a question of fact existed as to whether the amount in questionhad been determined with reasonable accuracy. The amount was to be determined based on an agreed formula, butcertain disagreements between the parties existed as to the amount of certain variables to be taken into account inapplying the formula. Nevertheless, the court indicated that the parties had reached agreement on the minimum amountof the taxpayer's obligations.

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n229 See, e.g., Dixie Pine Prods. Co. v. Comm'r, 320 US 516, 519 (1944).

n230 See Joint Comm. on Tax'n, General Explanation of the Revenue Provisions of the Deficit Reduction Act of1984 (Dec. 31, 1984) (hereafter Blue Book), at 259. Note that this same type of evidence has not been sufficient topermit a deferral in the recognition of prepaid income. See discussion infra P 4.03[3].

n231 Kaiser Steel Corp. v. United States, 717 F2d 1304 (9th Cir. 1983). See also Crescent Wharf & WarehouseCo. v. Comm'r, 518 F2d 772 (9th Cir. 1975), rev'g 59 TC 598 (1973); General Dynamics Corp. v. United States, 773F2d 1224 (Fed. Cir. 1985), rev'd on other grounds, 481 US 239 (1987), where the court recognized the appropriatenessof using aggregates, pointing out the burden that would otherwise be imposed if an analysis were required on anindividual, case-by-case basis; Supermarkets General Corp. v. United States, 537 F. Supp. 759, 82-1 USTC P 9351 (D.NJ 1982), where the court pointed out that, although the first (or fixed obligation) prong of the all events test mayrequire analysis on a case-by-case basis, the second (or reasonable accuracy) prong of the all events test does not andallows determinations on the basis of aggregates; Tech. Adv. Mem. 200619020 (Dec. 15, 2005), where the NationalOffice of the IRS recognized the appropriateness of the use of estimates and aggregates in determining amounts withreasonable accuracy. But see Wien Consol. Airlines v. Comm'r, 528 F2d 735 (9th Cir. 1976); Milwaukee & SuburbanTransp. Corp. v. Comm'r, 367 US 906 (1961), vacating and remanding 283 F2d 279 (7th Cir. 1960).

n232 ESCO Corp. v. United States, 750 F2d 1466 (9th Cir. 1985).

n233 ESCO Corp. v. United States, 578 F. Supp. 738 (D. Or. 1983).

n234 See discussion infra P 4.04[1][a][ii].

n235 Treas. Reg. §§ 1.451-1(a), 1.461-1(a)(3);.

n236 See discussion infra P 4.04[3] regarding the economic performance requirement.

n237 Priv. Ltr. Rul. 7830003 (Apr. 13, 1978).

n237.0a Bentley Laboratories, Inc., 77 TC 152 (1981).

n237.0b See Bentley Laboratories, Inc., 77 TC 152, at 171, n.20 where the court responded to the taxpayer'sassertion that an amount could not be determined with reasonable accuracy because of the likelihood or possibility ofcertain post year-end events by stating that "petitioner has not called our attention to evidence in the record indicatingthat any such [real or] hypothetical events actually occurred, or even if they did occur that the effects thereof could nothave been reasonably anticipated." See also Blue Book, supra P 230, which confirmed that post year-end events couldbe taken into account in determining amounts with reasonable accuracy and that one of the reasons for enactment of theeconomic performance requirement of Section 461(h) was to limit the manner in which such post year-end events couldbe taken into account.

n237.1 See, e.g., Interex, Inc., 83 TCM 1306, TC Memo. 2002-57 (2002), aff'd, 321 F3d 55 (1st Cir. 2003), wherethe court denied the claimed deduction on the basis of the taxpayer's inability to determine the amount with reasonableaccuracy, such conclusion predicated in large part on the inadequacy of the taxpayer's supporting evidence, including alack of contemporaneous documentation. See also United States v. Delta Airlines, Inc., 255 F2d 501 (5th Cir. 1958),where the court concluded that, because the taxpayer could not reasonably have determined for its 1940 tax year that theCivil Aeronautics Board would in 1942 award additional amounts of compensation for services provided in 1940, therewas no basis for concluding that such additional compensation could have been ascertained with reasonable accuracyand, therefore, included in income in 1940.

n237.2 Chicago, Burlington & Quincy §§ v. United States, 455 F2d 993, 1019 (Ct. Cl. 1972), rev'd on othergrounds, 412 US 401 (1973) ("The requirement that estimates be "made with reasonable accuracy" means that estimates

Page 42Federal Tax Accounting P 4.04

must be based on the best available information.").

n237.3 General Dynamics Corp. v. United States, 6 Cl. Ct. 250, 256 (1984), aff'd, 773 F2d 1224 (Fed. Cir. 1985),rev'd on other grounds, 481 US 239 (1987) (court stated with respect to determining amounts with reasonable accuracy:"[A]lthough it would have been theoretically possible to canvas their [thousands of] employees in an effort to determinethe approximate amount of their liability, as of December 31, 1972, such a procedure would have been prohibitivelyexpensive and overly burdensome."); Capital One Fin. Corp., 133 TC No. 8 (2009), aff'd, F3d , 108 AFTR2d 2011-6875(4th Cir. 2011), (Commissioner asserted that the most accurate way of calculating OID for a credit card issuer wouldhave been on a cardholder-by-cardholder basis, but conceded that the sheer number of cardholders would make suchcalculations burdensome, and for this and other reasons, the court declined to require such a computation). However, itis incumbent on the taxpayer to provide some evidence of the reasonableness of the amount he seeks to deduct. SpitzerColumbus, Inc., 70 TCM 448, TC Memo. 1995-397 (1995).

n237.4 Harrold v. Comm'r, 192 F2d 1002 (4th Cir. 1951).

n237.5 Denise Coal Co. v. Comm'r, 271 F2d 930 (3d Cir. 1959).

n237.6 See, e.g., Patch v. Comm'r, 208 F2d 532 (3d Cir. 1953); Comm'r v. Gregory Run Coal Co., 212 F2d 52(4th Cir.), cert. denied, 348 US 828 (1954).

n237.7 See Joint Comm. on Tax'n, 98th Cong., general explanation of the revenue provisions of the DeficitReduction Act of 1984, at 295 (Dec. 31, 1984) ("Generally, estimates based on industry-wide experience or theexperience of the taxpayer have been accepted by the courts as reasonable.").

n237.8 See, e.g., General Dynamics Corp. v. United States, 6 Cl. Ct. 250, 256 (1984), aff'd, 773 F2d 1224 (Fed.Cir. 1985), rev'd on other grounds, 481 US 239 (1987); Kaiser Steel Corp. v. United States, 717 F2d 1304, 1309, 1310(9th Cir. 1983) (referring to 7 percent difference between initially determined amount and later determined actualamount as only "modest inaccuracy"); Esco Corp. v. United States, 750 F2d 1466, 1468-1469 (9th Cir. 1985) (pointingout that while hindsight evaluations were relevant, they were not dispositive, key consideration being whetherdeterminations could have been expected to be reasonably accurate at time they were made).

n237.9 Spitzer Columbus, Inc., 70 TCM 448, TC Memo. 1995-397 (1995).

n237.10 Convergent Technologies, Inc., 70 TCM 87, TC Memo. 1995-320 (1995).

n237.11 ESCO Corp. v. United States, 750 F2d 1466 (9th Cir. 1985).

N238 See, e.g., McGowan, "Structured Settlements: Deduct Now and Pay Later," 60 Taxes 251 (1982).

n238.1 While the economic performance rules affect the time when the all events test will be deemed satisfied,Congress has sometime sought to curb potential abuse in a more limited manner. For example, Section 461(d) prohibitsan acceleration in the time when a deduction for state taxes will otherwise be permitted, if such acceleration is the resultof state tax legislation that accelerated the assessment or lien date of the state taxes in question, provided that any suchaction by a state taxing jurisdiction (1) was taken after December 31, 1960, and (2) would have accelerated the accrualdate used for federal income tax purposes. The purpose of this Code Section was to prevent effect being given to statelegislation designed to benefit state taxpayers by accelerating the time when they would obtain a federal tax deductionfor state taxes. See also Charles Schwab Corp., 122 TC 191 (2004).

n239 Blue Book, supra P 230, at 260-261.

n240 Prop. Reg. § 1.461-4.

n241 Treas. Reg. § 1.461-4.

Page 43Federal Tax Accounting P 4.04

n241.1 See, e.g., Rameau A. Johnson v. Comm'r, 184 F3d 786 (8th Cir. 1999), where the court found therelationship between items of income and expense to be so close in the particular circumstances that it allowed thetaxpayer to deduct the expenses in the same year the taxpayer was required to recognize the related incomenotwithstanding the fact that economic performance had not then occurred with respect to the expenses.

n242 Section 461(h) is effective for amounts that would be allowable as a deduction after July 18, 1984. Under thetemporary regulations (Temp. Reg. § 1.461-3T, which was later redesignated by the final regulations, effective April 10,1992, as § 1.461-7T), taxpayers are to apply the new rules to deductions that otherwise would have occurred after July18, 1984. Alternatively, taxpayers may elect to treat the application of Section 461(h) as a change in accounting methodeffective for the first taxable year that includes July 19, 1984. In addition, a taxpayer making that election may furtherelect to treat the change in accounting method as effective for the entire taxable year or for only that part of the taxableyear that begins with July 19, 1984. The temporary regulations are set forth in question-and-answer style, and numerousexamples are provided.

n243 See discussion supra P 4.04[1][a].

n244 See discussion infra P 4.04[3][b].

n245 Treas. Reg. § 1.461-4(d)(6)(ii).

n246 See discussion infra P 4.04[3][f].

n247 Id.

n248 Section 461(h) will not apply to items covered by Section 166(c) or Section 166(f), which relate to reservesfor bad debts, by Section 463, which relates to vacation pay, by Section 466, which relates to discount coupons, or byany other provision that expressly provides for the deduction of a reserve for estimated expenses. IRC § 461(h)(5). Inaddition, Treas. Reg. § 1.461-1(a)(2)(iii) provides that if any provision of the Code requires a liability to be taken intoaccount in a taxable year later than the taxable year provided under Section 461, the liability must be taken into accountin accordance with that Code provision. Similarly, these same regulations make it clear that Section 461 does notgovern the timing of a deduction for liabilities attributable to Sections 165, 170, 194A, 468, or Section 468A. Nor dothe regulations apply to any amount that the Code allows as a deduction for a reserve for estimated expenses. Finally,these regulations make it clear that except as otherwise provided by regulation, revenue procedure, or revenue ruling,the requirements of Section 461(h) and the regulations promulgated thereunder are satisfied to the extent that anyamount is allowable as a deduction under Sections 404, 404A, or 419. See Jimmy D. Weaver, 121 TC 273 (2003), for ananalysis of the relationship between Section 461(h) and Section 404(d), the court concluding that the economicperformance requirement of Section 461(h) was not satisfied, because the amounts in question were not paid within twoand one-half months after the taxpayer's year end as required by regulations under Section 404; Maxus Energy Corp. v.United States, 31 F3d 1135 (Fed. Cir. 1994), for an analysis of the relationship between Section 461(h) and Section468B, the court concluding (1) that Section 468B does not define the sole basis upon which a payment to a settlementfund in satisfaction of a liability is immediately deductible, and (2) that Section 468B does not apply to a contestedliability within the meaning of Section 461(f).

n249 See, e.g., Joseph W. La Rue, 90 TC 465 (1988), where the Tax Court held that the time for including aliability in the basis of a partnership interest is controlled by the time the liability has satisfied the all events test fordeductions under an accrual method.

n250 See discussion infra P 4.04[3][f].

n250.1 See, e.g., Rev. Rul. 2007-3, 4 IRB 376, where the IRS recognized this point in discussing application of thefixed liability prong of the all events test to liabilities for services and insurance. In each case, the IRS concluded thatthe fact of liability is not established upon mere execution of a contract but only at the earlier of the time (1) when

Page 44Federal Tax Accounting P 4.04

services are rendered or insurance is provided under the contract or (2) payment is due. See also Rev. Proc. 2007-14, 4IRB 357, for rules governing changes in methods of accounting required as a result of Rev. Rul. 2007-3.Notwithstanding Rev. Rul. 2007-3, because all facts and circumstances must be taken into account in determining whena liability actually becomes fixed, this ruling may not be applicable in every case. Consideration must still be given tothe particular terms and conditions of relevant contracts, applicable federal or state laws and regulations, the parties'course of dealing, and so forth. See, e.g., Volvo Cars of N. Am. LLC v. United States, 571 F3d 373 (4th Cir. 2009),where the court took into account, as required by applicable state law, the relevant commercial context and the parties'course of performance (as well as other applicable facts and circumstances) in determining how a particular agreementshould be interpreted; and discussion supra P 4.04[1], this supplement. In addition, it must keep in mind that, althoughservices may be rendered within the eight-and-one-half-month period following the close of the taxable year andtherefore may satisfy the economic performance prong of the all-events test, the fixed liability prong of that test is anindependent prong, the satisfaction of which must be separately determined. If the fixed liability arises at the timeservices are performed, then that prong would not have been satisfied in an earlier year, even though the recurring itemexception causes the economic performance prong to be satisfied in that earlier year. On the other hand, if the applicableagreement required payment by the end of the earlier year, the IRS's position is that the fixed liability prong is satisfiedin the earlier year, because that is the year in which the relevant amount is due and payable. See, e.g., In re Edward J.Waters v. United States, 2009 TNT 75-13 (Bankr. DC 2009), a non-published opinion recognizing this point.

n251 Section 461(h)(2) provides, "Except as provided in regulations prescribed by the Secretary, the time wheneconomic performance occurs shall be determined under [rules provided in IRC Sections 461(h)(2)(A)-461(h)(2)(D)]."

n252 Section 461(h) is applicable to all amounts that would be deductible after July 18, 1984, the date ofenactment.

n253 Prop. Reg. § 1.461-4.

n254 See discussion infra P 4.04[3][b][iv].

n255 Treas. Reg. § 1.461-4(g)(7).

n256 Id.

n257 IRC § 461(h)(2)(A).

n258 See discussion infra P 4.04[3][c].

n258.1 See, e.g., Rameau A. Johnson, 108 TC 448 (1997), where the court permitted the taxpayer to assume thatservices would be rendered in equal annual increments over the maximum period during which such services could beprovided. Notwithstanding the Tax Court's attempt to reach a reasonable result on this issue, the court was reversed onthis point by the Court of Appeals for the Eighth Circuit, that court concluding in the particular circumstances that itwould be unfair to require inclusion of the income but to defer deduction of the related expenses, notwithstanding thefailure of the expenses to satisfy the economic performance rules in that year. Rameau A. Johnson, 184 F3d 786 (8thCir. 1999).

n258.2 IES Indus., Inc. v. United States, 253 F3d 350 (8th Cir. 2001). See also Denis H. Dieker, 90 TCM 329, TCMemo. 2005-225 (2005), where the parties disagreed over the time when economic performance occurred. The taxpayerargued that economic performance occurred as certain services were provided for its benefit. The Commissioner arguedthat economic performance arose out of the taxpayer's breach of a particular agreement that gave rise to the need for theservices in question. After carefully considering the facts, the court determined that the proper obligation to considerwas the taxpayer's obligation to the provider of services and, hence, economic performance occurred as those serviceswere rendered. The mere fact that the services were required as a result of the taxpayer's breach of an agreement withanother party did not cause a change in the time that the relevant economic performance occurred. The court made it

Page 45Federal Tax Accounting P 4.04

clear that, in evaluating the liability at issue, it is important to consider not only the original liability, but also successorliabilities and the parties to whom the particular liabilities are owed. In this case, a taxpayer/contractor's breach of anagreement required another contractor to perform services. The relevant liability was found to be the taxpayer's liabilityto the other contractor for the services it performed.

n259 Although this might seem a strained interpretation, it is one that has been suggested by Treasury officials inpanel discussions with members of the American Bar Association.

n260 Prop. Reg. § 1.461-4.

n261 Treas. Reg. § 1.461-4.

n262 See discussion infra P 4.04[3][c][ii].

n263 IRC § 461(h)(2)(B).

n264 See, e.g., Gillis v. United States, 402 F2d 501 (5th Cir. 1968), where taxpayer allowed to accrue in currentyear loss on sale that must occur in subsequent year; Pacific Grape Prods. v. Comm'r, 219 F2d 862 (9th Cir. 1955),where taxpayer was allowed to deduct in one year anticipated expenses of shipping goods in subsequent year.

n265 Prop. Reg. § 1.461-4.

n266 Treas. Reg. § 1.461-4.

n267 See discussion infra P 4.04[3][c][ii].

n268 IRC § 461(h)(2)(C).

n269 See Treas. Reg. § 1.461-4(g)(5). See infra P 4.04[3][c][ii].

n270 Prop. Reg. § 1.461-4.

n271 Treas. Reg. § 1.461-4.

n272 See discussion infra P 4.04[3][c][ii].

n273 See discussion P 4.04[3][b][i]-P 4.04[3][b][iii].

n274 IRC § 461(h)(2)(D). Nevertheless, the report of the Conference Committee indicates that (1) with respect todisposal of nuclear wastes, the regulations should provide that economic performance occurs as payments are made tothe federal government and (2) with respect to deduction of refunds made to customers by natural gas utility companiesof refunds it receives from its suppliers, the deduction should be made in the year in which the refund is received if therefunds are passed through to the utilities customers within a reasonable period following the year of receipt andadequate interest is paid to customers and includable in their incomes.

n275 Prop. Reg. § 1.461-4.

n276 Treas. Reg. § 1.461-4.

n277 See discussion infra P 4.04[3][c][ii].

n278 But see Section 461(h)(2)(A)(iii) regarding rent.

n279 Blue Book, supra P 230, at 265.

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n280 See Don P. Setliff, 53 TCM 1295, TC Memo. 1987-330 (1987), where the court, in finding the Rule of 78'smethod of allocating interest to be inappropriate in the particular circumstances, nevertheless indicated thatcircumstances might exist where the use of that method (or, arguably, any other method agreed on by the parties) wouldclearly reflect income. This holding calls into question the validity of the position expressed by the IRS in Rev. Rul.83-84, 1983-1 CB 97. See discussion at P 3.03[3][a]. However, in Bruce A. Prabel, 91 TC 1101 (1988), aff'd, 882 F2d820 (3d Cir. 1989), the full Tax Court concluded that the Commissioner did not abuse his discretion in disallowing thatportion of interest deductions determined under the Rule of 78's method that were in excess of the amounts determinedunder an economic accrual method. The court noted that use of the Rule of 78's produced interest significantly in excessof both the economically accrued interest and the amounts of interest to be paid in most years. The court also noted thatunder the particular agreement, the Rule of 78's method of allocation would not have been used unless there were aprepayment. Subsequently, in Allen J. Levy, 92 TC 1360 (1989), the Tax Court again denied a taxpayer the right toaccrue and deduct interest on a Rule of 78's basis even though the Rule of 78's method would be applied in determiningthe amount of interest accrued and earned by the lender in all cases and not merely in the event of prepayment. Thecourt stated that the key point in Prabel was that where interest accruals calculated under the Rule of 78's methodmaterially exceed both the interest determined under an economic accrual method and the amount of interest thetaxpayer is required to pay under the applicable payment schedule, the Commissioner has the authority to remedy theresulting distortion in income. In light of these cases, it would appear that the only remaining issue is whether accrualunder a Rule of 78's method would be allowed where the difference between the Rule of 78's method and an economicaccrual method is material but the interest required under the Rule of 78's method actually is paid. On the other hand,the Claims Court recognized that whether use of the Rule of 78's method clearly reflects income is a question of fact forconsideration by the court. Mulholland v. United States, 92-1 USTC P 50,267 (Cl. Ct. 1992).

n281 Treas. Reg. § 1.461-4.

n282 Treas. Reg. § 1.461-4(d)(6)(i).

n283 Treas. Reg. § 1.461-4(d)(2)(ii).

n284 Treas. Reg. § 1.461-4(d)(6)(ii).

n285 See discussion of recurring item exception infra P 4.04[3][f].

n286 Treas. Reg. § 1.461-4(d)(3).

n286.1 For an interesting issue, see ABC Beverage Corp. v. United States, 577 F. Supp. 2d 935 (WD Mich. 2008),where, in denying a motion for summary judgment, the court stated that a genuine issue of fact existed over when theeconomic performance requirement will be deemed satisfied in a situation in which a taxpayer that leased property (andin connection with that lease, paid property taxes, provided insurance on the property, and maintained the property)exercised an option in the lease agreement to purchase the property. The court concluded that it could not determine onthe basis of the facts presented in the motion for summary judgment whether the economic performance requirementhad been satisfied, although it was clear that the economic performance requirement at issue pertained to the transfer ofproperty to the taxpayer rather than to its use of property.

n287 Treas. Reg. § 1.461-4(d)(6)(iii).

n288 See discussion supra P 4.03[1][a], and P 6.05[1][b].

n289 See discussion at P 9.06.

n290 Treas. Reg. § 1.461-4(d)(6)(iv).

n291 Treas. Reg. § 1.461-4(d)(4).

Page 47Federal Tax Accounting P 4.04

n292 See examples 2, 3, and 4 under Treas. Reg. § 1.461-4(d)(7). See also Section 263A and the regulationsthereunder for rules relating to the capitalization and inclusion in inventory of such incurred costs.

n293 Treas. Reg. § 1.461-4(d)(4)(ii).

n294 Treas. Reg. § 1.461-4(g)(7).

n295 Treas. Reg. § 1.461-4(g)(2).

n296 Treas. Reg. § 1.461-4(g)(2)(i).

n297 Treas. Reg. § 1.461-4(g)(2)(ii).

n298 Treas. Reg. § 1.461-5(c). The recurring item exception is discussed infra P 4.04[3][f].

n299 Treas. Reg. § 1.461-4(g)(3).

n300 Treas. Reg. § 1.461-4(g)(4).

n301 Treas. Reg. § 1.461-4(g)(5).

n302 Treas. Reg. § 1.461-4(g)(6).

n303 Treas. Reg. § 1.461-4(g)(6)(iii). In Ann. 91-89, 1991-25 IRB 48, the IRS announced guidance regarding theelection under Section 461(c) for ratably accruing real property taxes. The IRS stated that the final Section 461(h)regulations would provide rules allowing taxpayers automatically to make or to revoke an election under Section 461(c)without regard to the 180-day limitation period provided in Treas. Reg. §§ 1.461-1(c)(3)(ii), 1.461-1(c)(3)(iv),1.446-1(e)(3); and Rev. Proc. 83-77, 1983-2 CB 594. The automatic election or revocation would be available for thefirst taxable year in which the payment rule of then Prop. Reg. § 1.461-4(g)(6) was effective. At the time of its adoptionof final regulations, the Treasury announced that applicable rules governing these elections would be provided in Rev.Proc. 92-28, 1992-1 CB 745.

n304 Treas. Reg. § 1.461-4(g)(1).

n305 Id., but see Treas. Reg. § 1.461-6 providing certain circumstances in which certain liabilities are assigned orare extinguished by the establishment of a particular type of fund. See P 3 for a discussion of the cash method.

n306 Treas. Reg. § 1.461-4(g)(1)(ii)(A).

n307 Treas. Reg. § 1.461-4(g)(1)(ii)(B).

n308 Id.

n309 See discussion of constructive receipt at P 3.03[2].

n310 Treas. Reg. § 1.461-4(g)(1)(ii)(C). See also Treas. Reg. § 1.461-4(d)(5).

n311 Treas. Reg. §§ 1.461-4(d)(5)(ii), 1.461-4(g)(1)(ii)(C)(2).

n312 Treas. Reg. § 1.461-4(g)(1)(ii)(C)(3), as further revised by Ann. 92-30, 1992-9 IRB 38.

n313 Treas. Reg. § 1.461-4(k)(1).

n314 Treas. Reg. § 1.461-4(k)(2).

Page 48Federal Tax Accounting P 4.04

n315 See discussion at P 8.04[4], P 8.06[2].

n316 Blue Book, supra P 230, at P 266.

n317 Id., at 266.

n318 Treas. Reg. § 1.446-1(c)(1)(ii)(B).

n319 Id. See also Treas. Reg. § 1.61-3(a), amended in 1992 to provide that "[a]n amount cannot be taken intoaccount in the computation of cost-of-goods sold any earlier than the taxable year in which economic performanceoccurs with respect to that amount;" and Treas. Reg. § 1.263A-1(c)(2)(ii), amended in 1994 to provide that aninventoriable cost "may not be included in inventory [i.e., taken into account in determining cost of goods sold] anyearlier than the taxable year during which the amount is incurred within the meaning of section 1.446-1(c)(1)(ii)."Although these regulations certainly assume the application of the economic performance rules to cost of goods sold, nocourt has yet concluded that these rules are so applicable. In this regard, see discussion at P 6.02 pointing out that costof goods sold is not a deduction but an offset to income in determining income under Section 451. But see alsoPennzoil-Quaker State Co. v. United States, 2004-2 USTC P 50,398 (Fed. Cl. 2004); and Denis H. Dieker, 90 TCM 329,TC Memo. 2005-225 (2005), each of which assumed, or referred to, the application of the economic performance rulesto inventoriable costs, although that was not an issue in either case. Pennzoil-Quaker was subsequently reversed by theCourt of Appeals for the Federal Circuit. Pennzoil-Quaker State Co. v. United States, 511 F3d 1365 (Fed. Cir. 2008).The Court of Appeals did not refer to the economic performance rules, but did point out that cost of goods sold is not adeduction from income, but is an expenditure a taxpayer is entitled to subtract from gross receipts in the process ofcomputing income. See also Max Sobel Wholesale Liquors v. Comm'r, 630 F2d 670 (9th Cir. 1980), where, in affirmingthe decision of the Tax Court, the Court of Appeals held that the regulations in question were invalid insofar as theyattempted to place Section 162 limitations on cost of goods sold.

n320 Rev. Proc. 75-25, 1975-1 CB 720.

n321 Prop. Reg. § 1.461-4 (Preamble).

n322 Notice 91-4, 1991-4 IRB 19.

n323 These rules were provided in Rev. Proc. 92-29, 1992-1 CB 748.

n323.1 See Rev. Rul. 2007-3, 4 IRB 376, where, in the context of discussing the application of the all events test toliabilities for insurance and services, the IRS made it clear that mere satisfaction of the recurring item exception for aparticular tax year does not, by itself, establish that a liability has become fixed in that taxable year. The ruling explainsthat a liability will generally arise or become fixed for purposes of the all events test at the earlier of the time (1)services are rendered or insurance provided under the applicable contract or (2) payment is due, and not merely at thetime the contract is executed. See also Rev. Proc. 2007-14, 4 IRB 357, providing applicable procedures for changing amethod of accounting if required to do so as a result of Rev. Rul. 2007-3.

n324 IRC § 461(h)(3)(C).

n325 IRC § 461(h)(3)(A). See also Treas. Reg. § 1.461-5.

n326 See IRC § 6081.

n327 Treas. Reg. § 1.461-5(b)(1)(ii).

n328 Treas. Reg. § 1.461-5(b)(2).

n329 Treas. Reg. §§ 1.461-5(b)(2), 1.461-5(b)(3).

Page 49Federal Tax Accounting P 4.04

n330 Blue Book, supra P 230, at 263.

n331 Blue Book, supra P 230, at 263.

n332 Treas. Reg. § 1.461-5(b)(3).

n333 Treas. Reg. § 1.461-5(b)(4)(i).

n334 Treas. Reg. § 1.461-5(b)(4)(ii).

n335 Treas. Reg. § 1.461-5(b)(4)(iii).

n336 Blue Book, supra P 230, at 263.

n337 Id. at 264.

n338 Id.

n339 Treas. Reg. § 1.461-5(b)(4).

n340 Treas. Reg. § 1.461-5(b)(5).

n341 Prop. Reg. § 1.461-5(d), as revised by Notice 91-10, 1991-11 IRB 9. Notice 91-10 delayed the proposedeffective date of these rules for one year. Ann. 92-30, 1992-9 IRB 38, provided that the final regulations would bedelayed for one more year. Accordingly, the IRS stated that the final regulations would substitute "December 31, 1991,"for "December 31, 1989." The IRS added that the final regulations also would permit a taxpayer to change to therecurring item exception for the first taxable year beginning after December 31, 1989, or December 31, 1990, on eitherthe original return for the taxable year or an amended return for the taxable year. The IRS recognized that this wouldamount to allowing a retroactive change. The manner of making the change was to be prescribed in the final regulations.

n342 Treas. Reg. § 1.461-5(d).

n343 See discussion supra P 4.03[2].

n343.1 See, e.g., In re Dow Corning Corp., 88 AFTR2d 2001-7262, 2002-1 USTC P 50,155 (ED Mich. 2001),where the court stated: "Unless the parties to an agreement or applicable law stipulate otherwise, solvency is irrelevantto the question of whether a debt is contingent."

n344 See Fahs v. Martin, 224 F2d 387 (5th Cir. 1955); Keebey's, Inc. v. Paschal, 188 F2d 113 (8th Cir. 1951);Zimmerman Steel Co. v. Comm'r, 130 F2d 1011 (8th Cir. 1942).

n345 Helvering v. Russian Fin. & Constr. Corp., 77 F2d 324 (2d Cir. 1935); United Control Corp., 38 TC 957(1962), acq. 1966-1 CB 3. See also Gold Coast Hotel & Casino v. United States, 158 F3d 484 (9th Cir. 1998), whichinvolved a taxpayer that awarded prizes to customers who had accumulated at least 1,200 points in a prize program runby the taxpayer. An issue in the case was whether the taxpayer's obligation to customers who had accumulated suchpoints was sufficiently fixed to be deducted, since it was unlikely that all customers entitled to prizes would actuallyseek them. The court held that the obligations were fixed and therefore allowed the deductions, the court pointing outthat this particular prong of the all-events test would be satisfied where "there [was] a "reasonable expectancy" of theobligation being converted into cash or its equivalent [i.e., paid]."

n346 In SEC v. HJH, Inc., No. CA3-76-1611-F (D. Tex. 1979), an unreported decision, the district court found thata taxpayer that was then in receivership and did not have sufficient funds to pay the liability in question nor anyprospect of obtaining such funds was nevertheless entitled to a deduction.

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n346.1 See, e.g., Newhouse Broad. Corp., 80 TCM 178, TC Memo. 2000-244 (2000), where a publisher wasobligated to its authors to pay royalties on books sold, but also was entitled to a reduction in the amount of that liabilityfor books returned. (The publisher withheld a portion of the full amounts owed to authors to take into account the factthat books would be returned, and the deductibility of the retained portion was the issue before the court.) The courtfound that the liability for the full amount was fixed, but was subject to a condition subsequent, i.e., the possibility(indeed likelihood) that some books would be returned. Nevertheless, the mere fact that events were likely to occur inthe future that would result in a reduction in the amount of the liability, did not preclude the full amount of the liabilityfrom being fixed and deductible at the time of original sale.

n347 The IRS has distinguished (1) a fixed liability to pay an expense and (2) the accrual method taxpayer'sultimate ability to pay that expense in three revenue rulings. In Rev. Rul. 70-367, 1970-2 CB 37, the IRS discusseddeduction-of-interest obligations by a taxpayer undergoing a bankruptcy reorganization "when the financial condition ofthe corporation is such that there is no reasonable expectancy that it will pay the accrued interest in full." The IRS ruledthat "[t]he doubt as to the payment of such interest is not a contingency of a kind that postpones the accrual of theliability until the contingency is resolved." Id. This ruling may be read in the context of a deferral of payment ratherthan ultimate nonpayment, but the IRS's presentation of facts was not this restrictive. In Rev. Rul. 72-34, 1972-1 CB132, 133, the IRS stated that "where there exists a contingency as to payment of an obligation, and such contingencyrelates to other than the ability of the obligor to pay, it cannot be said that the obligation is fixed within the meaning ofsection 1.461-1(a)(2) of the regulations." This implies that doubt as to the taxpayer's ability to pay does not bar adeduction if the obligation is otherwise fixed. Finally, in Rev. Rul. 77-266, 1977-2 CB 236, the IRS permitted adeduction, noting that "[a]lthough a loss year might reduce the company's assets and thus delay the availability tomembers of payments otherwise maturing, this event would relate to the company's ability to pay rather than to theamount of the company's liability to the member."

n347.1 See, e.g., In re Dow Corning Corp., 88 AFTR2d 2001-6272, 2002-1 USTC P 50,155 (ED Mich. 2001),where the court noted the possible unfairness of depriving otherwise legitimate deductions to entities that are infinancial difficulty, particularly since it is not clear that the federal government would substantially enhance its revenuesby disallowing such deductions and that such a denial may only serve to accelerate the very demise of the business.

n348 If existence or fruition of the liability itself is contingent upon ability to pay, the deduction may be denied.See, e.g., Putoma Corp. v. Comm'r, 601 F2d 734 (5th Cir. 1979), where deductions for accrued bonuses were deniedbecause liability for such bonuses was conditioned on a determination by the directors of the taxpayer that the taxpayerhad sufficient cash reserves to pay the amounts in question; Restore, Inc., 74 TCM 1475, TC Memo. 1997-571 (1997),aff'd without opinion, 174 F3d 203 (11th Cir 1999), where a deduction for royalties (and interest on those royalties) wasdenied because of an understanding among the parties that such royalties (and interest) would not be due unless anduntil the taxpayer began to show a profit; see also ABKCO Indus. Inc. v. Comm'r, 482 F2d 150 (3d Cir. 1973).

n348.1 West Texas Marketing Corp. v. US, 95-1 USTC P 50,296 (5th Cir. 1995).

n348.2 The majority was also influenced by Guardian Inv. Corp. v. Phinney, 253 F2d 326 (5th Cir. 1958), where ataxpayer sought to deduct interest on a second mortgage even though no payments of such interest would be due untilpayment of the first mortgage. The court held the second mortgage debt to be contingent on payment of the firstmortgage debt.

n348.3 The dissent also suggested that the majority's opinion was inconsistent with Fahs v. Martin, 224 F2d 387(5th Cir. 1955), and thereby infused the law with what was likely to become continuing uncertainty.

n349 Tampa & Gulf Coast R.R. v. Comm'r, 469 F2d 263 (5th Cir. 1972).

n350 "Tampa also refers to the general principle that an accrual method taxpayer's inability to pay interestobligations does not prevent deductibility. [citing Fahs] We believe the principle gives away to the extreme

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circumstances in this case." 469 F2d at 264. See also In re Continental Vending Mach. Corp., 77-1 USTC P 9121(EDNY 1976)(denial of deduction for interest by taxpayer undergoing bankruptcy reorganization).

n351 Mooney Aircraft, Inc. v. United States, 420 F2d 400 (5th Cir. 1969).

n352 See Raymond W. Hodge, 32 TCM 277, TC Memo. 1973-64 (1973), where so-called bond warranty expenseswere not deductible in the year the bonds were issued to aircraft purchasers, because warranty bond was to be paid onlywhen aircraft was removed from service. But see Denise Coal Co. v. Comm'r, 271 F2d 930 (3d Cir. 1959), wherededuction was allowed even though payments were made eleven years after accrual; Reynolds Metals, Inc., 68 TC 943(1977), where deduction was allowed for liability to fund a trust even though funding would not be completed forthirteen years; John Ferenc, 33 TCM 136, TC Memo. 1974-30 (1974), where the court concluded that if the all eventstest were satisfied, deduction would be permitted.

n353 For example, in Burnham Corp., 90 TC 953 (1988), aff'd, 878 F2d 86 (2d Cir. 1989), the court allowed thetaxpayer to deduct the full amount of payments to be made over an estimated period of sixteen years. TheCommissioner argued that the deduction should be denied on the basis of Mooney Aircraft. However, the courtdistinguished that case on the basis that the payments in Mooney Aircraft were not to begin for a substantial period oftime, while the payments in Burnham Corp. were to begin shortly after accrual of the deduction.

n353.1 Ford Motor Co., 102 TC 87 (1994).

n353.2 But see City of New York, 103 TC 481 (1994), which was issued after Ford Motor Co., but held that in theabsence of an explicit statutory provision or clearly stated legislative intent to apply present value concepts, suchconcepts were not to be applied to limit or otherwise alter the amounts to be taken into account for tax purposes. Inother words, the court held that time value of money concepts were generally not applicable to proper tax reporting.

n354 See discussion of the tax benefit rule at P 12.05.

UPDATE-DATE: April 08, 2012

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