Accrual Accounting – When Can a Deduction Be Claimed?

Overview

To claim a deduction on the current year’s tax return, a taxpayer using the accrual method must generally show “economic performance” concerning the item(s) for which a deduction is sought and that all events have occurred determining a liability and that the amount of the liability can reasonably be determined.  Treas. Reg. §1.461-1(a)(2)(i). 

These points came up recently in a case involving a California business that provides bulk-packaged tomato products to food processors.  The company also provides customer-branded finished products to the food service industry.  The question was whether the company could increase its cost of goods sold (COGS) for the costs it incurred to restore, rebuild, recondition and retest their manufacturing facilities for the tax years in issue. 

Deducting Expenses

When it comes to claiming a tax deduction, a taxpayer can take it on the return in the tax year that is consistent with the method of accounting that the taxpayer uses to compute taxable income.  I.R.C. §461(a).  That means that for an accrual method taxpayer, a business expense can be deducted in the year the expense is incurred.  It doesn’t matter if the actual payment date is in a different year.  See, e.g., Caltex Oil Venture v. Commissioner, 138 T.C. 18 (2012), citing Treas. Reg. §1.461-1(a)(2).  So, when is an expense incurred?  It’s when an “all events” test is satisfied.  See Challenge Publications, Inc. v. Commissioner, T.C. Memo. 845 F.2d1541 (9th Cir. 1988).  Under the test, an item allowable as a deduction, cost or expense (liability) for federal income tax purposes is incurred if: 1) all of the events establishing the liability have occurred; 2) the amount of the liability is determinable with reasonable accuracy; and 3) economic performance has occurred.  Treas. Reg. § 1.446-1(c)(1)(ii)(B); I.R.C. §461(h)(4); Treas. Reg. §§1.461-1(a)(2); 1.461-4.  It must be fixed and absolute.  Brown v. Helvering, 291 U.S. 193 (1934).  It also must be unconditional. Lucas v. North Texas Lumber Co., 281 U.S. 11 (1930). 

The all events test isn’t satisfied, and a deduction isn’t allowed if the tax liability is contingent on the occurrence of a future event.  See Lucas v. American Code Co., 280 U.S. 445 (1930).  Conversely, a liability is established if the required performance is rendered or the date of payment is unconditionally due.  See, e.g., VECO Corp. & Subsidiaries. v. Comr., 141 T.C. 440 (2013).  Another way of stating the matter is that there must be something (such as a contract or a statute) that fixes the taxpayer’s obligation.  See, e.g., Exxon Mobil Corp. v. Commissioner, 114 T.C. 293 (2000); Amergen Energy Co., LLC v. United States, 113 Fed. Cl. 52 (2013).

Recent Case

In The Morning Star Packing Company, L.P., et al. v. Comr., T.C. Memo. 2020-142, the petitioner provided bulk-packaged tomato products to food processors and customer-branded finished products to the food service and retail trades.  The petitioner’s operation accounted for about 25 percent of the California processed tomato production and it supplied approximately 40 percent of the United States ingredient tomato paste and diced tomato markets.”  The petitioner operated around-the-clock during tomato harvest season, and operated under numerous state and federal food safety/cleanliness regulations.  Any violations (or even alleged violations) of those requirements could shut down the petitioner’s operation causing losses due to spoilage and contract defaults with growers and buyers.  Specifically, after the end of a tomato harvest season, the petitioner engaged in extensive clean-up.  If the petitioner didn’t engage in this meticulous post-harvest cleaning and the tomato line were to become contaminated all of the tomato products in the processing line would have to be dumped, the line sterilized at a large cost, and all had to be inspected by federal and state agricultural agencies.  In addition, farmer-sellers would have to be paid for their tomato crops and the petitioner would be in breach of the covenants contained in the credit lines (that required the petitioner to maintain its licenses and keep the equipment in good repair) with its lenders as well as its delivery contracts for processed tomatoes.   

The petitioner incurred costs to restore, rebuild, and retest the manufacturing facilities for use during the next production cycle. The accrued production costs included amounts to be paid for goods and services. The petitioner also maintained reserves to account for future costs associated with restoring, rebuilding, and retesting the manufacturing facilities for use during the next production cycle. The production accrual reserve accounts tracked amounts for production labor, boiler fuel, electricity, waste disposal, chemicals and lubrication, production supplies, repairs and maintenance, lease, production wages, and administration wages.

The accrued production costs were recurring, and the amounts set aside in the reserves covered the costs with reasonable accuracy.  IRS did not challenge the accuracy of the reserves.  The petitioner also documented the economic efficiency reasons why it delayed some of the restorative work as well as retesting and rebuilding work until near the beginning of the next production cycle.  

The petitioner deducted its clean-up costs (good and services, etc.) after a tomato harvest season in that tax year, even though the clean-up work actually occurred in the following tax year.  Economic performance of the production accrual liabilities didn’t occur until the petitioner’s next tax year.  At least that was the position of the IRS.  It claimed that the petitioner could not include the accrued costs in the cost of sales for the current year due to the economic performance requirement of I.R.C. §461(h)(3).  In particular, the IRS asserted that the petitioner couldn’t increase its COGS for the amount of the accrued production costs because the petitioner had not shown that all events had occurred to establish the fact of the liabilities. Economic performance had not occurred with respect to the liabilities to qualify for accrual for the years claimed – the third prong of the “all events” test. 

The petitioner claimed that it was entitled to the deduction because it had bilateral contracts for goods and services to recondition its manufacturing facilities, and that all events had occurred during the tax years in issue to establish the fact of the liabilities for the accrued production costs.  The petitioner also took the position that its credit agreements and multiyear contracts to supply customers with tomato products obligated them to incur the accrued production costs to restore, rebuild, and retest the manufacturing facilities.  The Tax Court disagreed.  The Tax Court noted that the credit agreements did not specifically set forth the petitioner’s obligations to provide a comparably sufficiently fixed and definite basis. Instead, the Tax Court concluded that the credit agreements included nonspecific text and generalized obligations that merely required to maintain its licenses and permits, and secure governmental approvals.  The agreements also also contained general language requiring the petitioner to comply with ‘all laws’, and ‘keep all property useful and necessary in its business in good working order and condition’. That language, the Tax Court concluded, didn’t specify which laws or regulations had to be complied with.  It also didn’t identify with any precision which property must be kept in good working order. The generalized obligations, the Tax Court reasoned, did not establish the petitioner’s  liabilities for the accrued production costs for the years in issue.  In addition, the Tax Court determined that the petitioner’s inclusion of the production costs in COGS for the years in issue result in a more proper match against income than inclusion in the taxable year. 

The petitioner also couldn’t avoid its tax problem by using a fiscal year from October 1 to September 30.  While good business reasons would have supported using such a fiscal year, I.R.C. §706 prevented it.

Conclusion

Clearly, and accrual basis taxpayer must closely scrutinize the liabilities that it seeks to deduct to make sure that all of the requirements of the all-events test  have been met to claim the deduction.  Satisfying the economic performance part of that test also requires careful drafting of credit agreements to fix the liabilities in the appropriate tax year.