Government Forces Sale to Cover Partner’s Tax Debt

 I was reading a case recently that bothered me. It involves something that – fortunately – I rarely see in practice.

Here is the Code section:

§ 7403 - Action to enforce lien or to subject property to payment of tax

(a) Filing. In any case where there has been a refusal or neglect to pay any tax, or to discharge any liability in respect thereof, whether or not levy has been made, the Attorney General or his delegate, at the request of the Secretary, may direct a civil action to be filed in a district court of the United States to enforce the lien of the United States under this title with respect to such tax or liability or to subject any property, of whatever nature, of the delinquent, or in which he has any right, title, or interest, to the payment of such tax or liability. For purposes of the preceding sentence, any acceleration of payment under section 6166(g) shall be treated as a neglect to pay tax.

(b) Parties. All persons having liens upon or claiming any interest in the property involved in such action shall be made parties thereto.

(c) Adjudication and decree. The court shall, after the parties have been duly notified of the action, proceed to adjudicate all matters involved therein and finally determine the merits of all claims to and liens upon the property, and, in all cases where a claim or interest of the United States therein is established, may decree a sale of such property, by the proper officer of the court, and a distribution of the proceeds of such sale according to the findings of the court in respect to the interests of the parties and of the United States. If the property is sold to satisfy a first lien held by the United States, the United States may bid at the sale such sum, not exceeding the amount of such lien with expenses of sale, as the Secretary directs.

(d) Receivership. In any such proceeding, at the instance of the United States, the court may appoint a receiver to enforce the lien, or, upon certification by the Secretary during the pendency of such proceedings that it is in the public interest, may appoint a receiver with all the powers of a receiver in equity.

And here is where you leave your tax CPA and hire a tax attorney.

Section 7403 permits a court to authorize the sale of property when a delinquent person owns property with a nondelinquent person. The IRS cannot do this on its own power, however; it must first go to district court and obtain approval.

To be fair, one is deep into the IRS Collection machinery before Section 7403 is even an issue. I would be screaming at you – and likely fired you as a client – long before we got here, unless bad fortune was involved. If there was bad fortune, we likely would be submitting an offer in compromise.

The heavyweight case in this area is United States v Rodgers. Rodgers was a Texas gambler who died, leaving a $900,000 tax debt. He (well, now his estate) and his wife owned their home. Under Texas law the surviving spouse had a lifetime right to live in the home. The government of course wanted its money.

The case went all the way to the Supreme Court, which identified four issues before the government could force any sale to collect taxes.

 (1) Statutory authority

Does the taxpayer have any “right, title or interest” to the property in question?

 

In Rodgers, yes. The deceased had the same rights to the entire home as did the widow.

 

The type of ownership can have a drastic effect on the government’s ability to reach the asset. A tenancy by the entirety, for example, might result in a different answer from a tenancy in common (which we will see below). 

            (2) Constitutional authority

This goes back to eminent domain. The government is not an ordinary creditor in this situation; rather it is exercising the prerogatives of a sovereign. Think of the government as a super creditor.

            (3) Practical undercompensation

Think actuarial calculations. For example, one could think that a 50/50 split of marital assets is fair. However, the value of a life estate to a surviving spouse aged fifty can be up to 95% of the home’s sales price. The spread between 95% and 50% is referred to as “practical undercompensation.”

            (4) Four-factor balancing test

             (a)  Will a non-sale prejudice the government?

   (b) Does the spouse have a legally recognized expectation of the house not being sold?

   (c)  Will the spouse suffer prejudice from practical undercompensation and dislocation costs?

   (d)  What are the relative characters and values of the two ownership interests?

Subsequent application of Rodgers focuses on these four factors.

Let’s move on to Driscoll.

Thomas Driscoll was a dentist. He owned a dental practice with Dr Vockroth. Together they also owned the building in which the dental practice was located.

Common enough.

Dr Driscoll became substantially delinquent with his tax obligations.

In April 2023, the government filed a motion for forced sale of both the practice and the building.

Meanwhile. Dr V had no tax issues. He may have made the mistake of partnering with someone who did, but that was the extent of his culpability.

The government – to its credit – allowed additional time to sell both assets.

But there were issues: trying to sell a dental practice in a small town and a building housing said practice in said small town. Let’s just say there was limited interest in buying either.

The government now wanted a forced sale.

Let’s go through the Rodgers four factors:

One

The Court decided Dr V could not show that the government would not be prejudiced by going after 50% rather than 100% of the practice and building.

Yes, the double negative is a bit difficult to follow.

This was a practice in a small town. It was going to be tough enough to sell without trying to sell half rather than the whole.

         The court decided that factor one weighed in favor of a sale.

         Two

Was Dr V as a tenant in common subject to a forced sale?

Here is the Court discussing the real estate:

This conclusion is also supported by the fact that, unlike tenants by the entirety or joint tenants, tenants in common enjoy no protections from forced sales or partition actions.”

Tough to be a tenant in common in New Jersey.

The court decided factor two weighed in favor of a sale.

Three

 Was there prejudice to Dr V in terms of personal dislocation of costs and undercompensation of interest?

Here is the Court:

 Dr Vockroth asserts that he will be ‘forced to lay off all of [his] employees,’ and that he will ‘no longer be able to see [his]  patients.'”

OK, Dr V may be laying it on thick, but that does not mean there is no truth here. Relocating a practice costs money. There are – for example - additional electrical and plumbing needs before a building can house a dental practice. Patients may not follow. Employees may not follow. The court is playing cavalierly with other people’s lives.

Here is the court in its best Frasier Crane voice:

 Furthermore, even if Dr Vockroth is negatively affected by the LLC in some way, this is not an undue prejudice of a magnitude to prevent a forced sale. It is axiomatic that LLCs and partnerships change, fail, dissolve and are bought and sold with regularity. Partners die or sell their shares The reality is simply part of being in business, and Dr. Vockroth is not exempt from this fact, especially when he fails to offer any reliable evidence to support his contentions.”

What is Dr V to do: poll his patients and employees to see whether they would follow? Oh, that will go swimmingly.

BTW the sale of a dental practice will certainly include a noncompete, meaning that Dr V could not open a dental practice within so many miles of the existing practice. Well, he could, but he would be sued.

One would think a judge would know that.

Four

  The relative character and value of the property owned by the two owners.

There was not much play here as both doctors owned 50%.

The court decided that the government could foreclose on both the practice and the real estate.

Technically right, but lousy law. Consider this menacement from Rodgers:

We do emphasize, however, that the limited discretion accorded by § 7403 should be exercised rigorously and sparingly, keeping in mind the Government's paramount interest in prompt and certain collection of delinquent taxes.

Section 7403 is not taxpayer friendly.

Our case this time was United States v Driscoll, 2025 BL 2655, D.N.J. No. 3:18-cv-11762, 1/6/25.

Section 643 and MSTs

 

I came across the following recently on LinkedIn:

 

The line of tax code that 99% of CPAs can’t understand for some reason.

And because they don’t understand this they make their clients tax planning convoluted and unnecessary.

26 U.S. Code § 643

(3) Capital gains and losses
Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in section 642(c). 

Stop, just stop.

There is a lot of nonsense going around on social media concerning something called - among other things – a “nongrantor, irrevocable, complex, discretionary, spendthrift trust.”

I just call it a “643 trust.” It is probably unfair as Section 643 has its legitimate place in the Code, but I simply cannot repetitively spray multisyllabic spittle when referring to these.

They have many forms, but one thing is key: Section 643. I met last year with someone who was hawking these things but was unable to find a CPA with his elevated mastery of the tax Code.

Uh huh. Elevator is down the hall, pal.

Let’s walk through these trusts.

The tax Code has numerous sections. Go to Chapter 1 Subchapter J and you will find sections dealing with trusts. You will note that they all have numbers between 641 and 692.

Section 643 is between 641 and 692. We are in the right place.

Trust taxation is not the easiest thing to understand. There are weird concepts. Then there are uncommon terms, such as:

 

·       The grantor – the person who transfers assets to the trust.

·       The income beneficiary – the person entitled to income distributions.

·       The residuary beneficiary – the person entitled to the remainder of the trust when the income beneficiaries are done.

·        Irrevocable trust – a trust where the grantor cannot amend or end the trust after its creation.

·       Complex trust – a trust that can accumulate (that is, retain) its profit.

·       Trustee – the person managing trust assets for the benefit of trust beneficiaries. A trustee is required to act in the best interest of the beneficiaries.

·       Discretionary trust – a trust allowing a trustee the power to decide how and when to distribute assets (including income) to beneficiaries.

Believe it or not, there are also several definitions of income, such as:

 

·       Fiduciary accounting income – income as defined by the trust instrument and state law.

·       Distributable net income – the maximum income available to the trustee for distribution to beneficiaries.

·       Taxable income – income as defined by the tax Code.

And - yes - you can get different answers depending on which definition of income you are looking at.

Why is that?

One reason is possible tension between different beneficiary classes. Say that you create a trust for your son and daughter as income beneficiaries. Upon their death, the remaining trust assets (called corpus) goes to the grandkids, who are the residuary beneficiaries. Your kids may want something to be considered income, as they are entitled to income distributions. The grandkids may prefer something not be considered income, as that something would not be distributed and thereby remain in the trust until eventual distribution to them.

What are common friction points between income and residuary beneficiaries? Here are two repetitive ones: capital gains and depreciation.

For example, one may consider depreciation as a reserve to replace deteriorating physical assets. In that case, it makes sense to allocate depreciation to the residuary beneficiaries, as the assets will eventually go to them. Then again, accountants routinely include depreciation as a current period expense. In that case, depreciation should go to the income beneficiaries along with other current period expenses.

Back to our multisyllabic spittle trust (MST).

Look at Section 643(b):

    26 U.S. Code § 643 - Definitions applicable to subparts A, B, C, and D

(b) Income.

For purposes of this subpart and subparts B, C, and D, the term "income", when not preceded by the words "taxable", "distributable net", "undistributed net", or "gross", means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.  

What is this Section trying to do?

Looks like it is trying to define “income” and failing rather badly at it.

Look at the last sentence:

… which the fiduciary, acting in good faith, … shall not be considered income.”

Hmmmmm.

But read the first sentence:

… when not preceded by the words “taxable ….”

Seems to me that last sentence could be the solution to the Riemann Hypothesis and it would not matter once you put the word “taxable” in front of “income.”

Let’s move on to Section 643(a):

Distributable net income.

For purposes of this part, the term “distributable net means, with respect to any taxable year, the taxable income of the estate or trust computed with the following modifications —  

(3) Capital gains and losses         

Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in section 642(c).  

(4) Extraordinary dividends and taxable stock dividends  

… there shall be excluded those items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, does not pay or credit to any beneficiary by reason of his determination that such dividends are allocable to corpus under the terms of the governing instrument and applicable local law.

I see the words “shall be excluded.”

I see the extraordinary dividends and taxable stock dividends from Section 643(b). And there is new wording about gains from the sale or exchange of capital assets. Is it possible …?

I also see the words “Distributable net income” at the top.

Let’s go back to our definitions of trust income.

Section 643(a) addresses distributable net income. Think of DNI as Mint Chocolate Chip.

Section 643(b) addresses taxable income. Think of TI as Cookies and Cream.

Mint Chocolate Chip is not Cookies and Cream.

Maybe capital gains are excludable from DNI. Maybe they are not. Either way, that conundrum has nothing to do with capital gains being excludable from taxable income.

The IRS is quite aware of the game being played.

Here is AM 2023-006:

 

One is dancing on the slippery beveled edge of a possible tax shelter.

Just leave these trusts alone. If I could make income nontaxable by running it through a string-a-bunch-of-words-together trust, I would have done so years ago. I might have even retired by now.

The IRS Goes Rounds With Cohan

 

The decision begins with the IRS seeking taxes of $805,149, $1,145,104, $1,161,864, and $831,771 for years 2013 through 2016. The penalties were unsurprisingly also enormous.

I want to know what happened here.

The taxpayer was Mohammad Nasser Aboui, and he was the sole shareholder of an S corporation called HPPO. He owned several used vehicle lots, and in 2009 he put them into HPPO as its initial corporate capitalization.

It sounds like a tough business:

·       Most of HPPO customers had bad credit.

·       Many did not have a checking account and instead paid HPPO in cash.

·       HPPO financed between 90% and 95% of its sales.

·       Customers repaid their loans less than 10% of the time.

·       HPPO repossessed approximately 25% of the cars it sold within 3 or 4 months.

·       HPPO had quite the barter system going with its mechanics: the mechanic would work on HPPO cars in exchange for rent of HPPO’s garage space.

Around 2014 Aboui decided to close the business. There were serious family health issues and HPPO was not making any money.

The IRS started its audit in September 2015.

HPPO’s accountant was ill at the time and later died.

To its credit, the IRS waited.

More than 3 years later HPPO engaged another accountant to represent the audit.

The second accountant made immediate mistakes, such as getting HPPO’s accounting method wrong when dealing with the IRS Revenue Agent (RA).

COMMENT: More specifically, the accountant told the RA that HPPO used the overall cash basis of accounting. HPPO did not. In fact, it could not because inventory was a material income-producing factor.

The RA wanted HPPO’s books and records, including access to its accounting software. HPPO could provide much but not the software. Its software license expired when it left the vehicle business in 2018.

This is a nightmare.

HPPO did eventually reactivate the software, but it was too late to help with the RA.

The RA – being told by the second accountant that HPPO used the cash basis of accounting – decided to use bank statements to reconstruct gross income.

BTW HPPO wound up dismissing the second accountant.

The results were odd: HPPO had reported more sales for 2013 through 2015 – nearly $3.25 million - than was deposited at the bank.

The pattern reversed in 2016 when HPPO deposited approximately $539 grand more than it reported in sales.

COMMENT: I have an idea what happened.

The RA also saw following bad debt expense:

          2013             $1,069,739

          2014             $ 668,537

          2015             $ 902,967

          2016             $ 436,738    

Here is something about the cash basis of accounting: you cannot have bad debt expense. It makes sense when you remember that gross income is reported as monies are deposited. Bad debts are receivables that are never collected, meaning there is nothing to deposit. One never leaves home plate.

So, the RA disallowed the bad debt expense entirely.

I am pretty sure about my earlier hunch.

The RA also determined that HPPO had distributed the following monies to Aboui, one way or another:

          2013             $2,476,301

          2014             $1,704,329

          2015             $1,406,893

2016             $1,934,033

There were other issues too.

Off they went to Tax Court.

Remember what I said about reactivating the accounting software license? Aboui now presented thousands of pages to document cost of sales and other expenses. The Court encouraged the IRS to accept and review the new records.

The IRS said, “nah, we’re good.”

COMMENT: Strike one.

The Court started its opinion with HPPO’s sales.

The RA stated to the Court that HPPO used the overall cash basis of accounting.

Don’t think so, said the Court. The Court saw HPPO using the accrual basis of accounting for sales and the cash basis of accounting for everything else.

COMMENT: This is referred to as a hybrid method: a pinch of this, a sprinkle of that. If one is consistent – and the results are not misleading – a hybrid is an acceptable method of accounting.

The Court asked Treasury why it thought that HPPO used the cash basis of accounting.

Treasury replied that it had never said that.

The Court pointed out that the RA had said that she understood HPPO to be a cash basis taxpayer. To be fair, that is what the second accountant had told her.

Nope, never used the cash method insisted Treasury.

COMMENT: An explanation is in order here. Treasury Department attorneys take over when the matter goes to Court. Perhaps the attorneys meant “direct” Treasury. The RA – while working for the IRS which itself is part of the Treasury – would then be “indirect” Treasury. I am only speculating, as this unforced error makes no sense. Clearly it bothered the Court.

Strike two.

The Court then reasoned why HPPO was reporting more sales than it deposited in the bank: it was reporting the total vehicle sale price in revenues at the time of sale. That also explained the bad debt expense: HPPO financed most of its sales and most of those loans went sour.

But why the reversal in 2016?

Aboui explained to the Court that by 2016 he was closing the vehicle business. He would have slowed and eventually stopped selling cars, with the result that he would be depositing more in the bank than he currently sold.

The Court decided that HPPO had correctly recorded its sales for the years at issue.

Next came the cost of vehicles sold.

This accounting was complicated because so much cash was running through the business. Sometimes cash was used to immediately pay expenses without first being deposited into a bank account – NOT a recommended accounting practice.

The RA had also identified certain debits to HPPO’s bank account that were either distributions or otherwise nondeductible.

The Court could find no evidence that those identified debits had been deducted on the tax returns.

The RA – and by extension, the … Treasury – was losing credibility.

Aboui meanwhile provided extensive documentation of HPPO’s expenses at trial. Some of these were records the Court had asked the IRS to accept and review – and which the IRS passed on.

Here is the Court:

Petitioners provided extensive documentation at trial to substantiate the COGS and business expenses. Mr. Aboui testified that HPPO was unprofitable. Given the record in its entirety, we find that petitioners have substantiated HPPO’s COGS and business expenses as reported on HPPO’s returns for each year at issue, except for meal and entertainment expenses of …..”

COMMENT: Strike three.

The Court went to the bad debts.

Mr. Aboui credibly testified that he was unable to repossess approximately 250 cars during the years at issue. The loss of these cars adequately substantiates the amount of HPPO’s bad debt deductions for the years at issue under the Cohan rule.”

The Court went to the distributions.

Respondent determined that petitioners failed to report approximately $7.5 million in taxable distributions from HPPO during the years at issue.”

COMMENT: Remember that HPPO is an S corporation, and Aboui would be able to withdraw his invested capital – plus any business income he had paid taxes on personally but left in the business – without further tax. This amount is Aboui’s “basis” in his S corporation stock.

Here is the Court:

Respondent argues that petitioners have not established Mr. Aboui’s basis in HPPO during the years at issue. We disagree and that the record and Mr. Aboui’s credible testimony provides sufficient evidence for us to reasonably estimate his basis under the Cohan rule.”

The IRS won a partial victory with the distributions. The Court thought Aboui’s basis in HPPO was approximately $5.1 million.

The IRS had wanted zero basis.

The effect was to reduce the excess distributions to $$2.4 million ($7.5 minus $5.1).

Still, it was a rare win for the IRS.

Excess distributions are taxable. Aboui had taxable distributions of $2.4 million. Yes, it is a lot, but it is also a lot less than the IRS wanted.

COMMENT: The nerd part of me wonders how the Court arrived at an estimate of $5.1 million for Aboui’s basis. Unfortunately, there is no further explanation on this point.

Oh, one more thing from the Court:

… we hold that petitioners are not liable for any penalties.”

While not contained within the four corners of this decision, I am curious why the Court repetitively went to the Cohan rule. I have followed this literature for years, and this result is not normal. Courts generally expect a business to maintain an accounting system that produces reliable numbers. Yes, every now and then there may be a leak in the numbers, and the court may use Cohan to plug said leak. That is not what we have here, though. This boat was sinking.

Perhaps Aboui presented his case well.

Mr. Aboui was incredibly forthright in his testimony.”

And perhaps the IRS should not have argued that an RA – an IRS employee – is not the IRS.

Our case this time was Aboui and Mizani v Commissioner, T.C. Memo 2024-106.

The Old Three And Two

 

You will recognize the issue.

During 2017 Mary deNourie worked at a retail store. She had wages of $11,516 and social security of $7,559. She and her husband did not file an income tax return because the withholding was enough to cover any tax due.

In 2021 the IRS contacted them about not filing a 2017 tax return. The IRS was preparing a substitute for return showing the wages and social security as well as partnership income of $25,065. When you throw the partnership into the mix, they now owed tax of $4,192, plus interest and penalties.

What partnership income, they exclaimed? The partnership had not paid them anything.

COMMENT: That is not the way partnerships are taxed. For example, a 10% partner will generally be taxable on 10% of the partnership’s taxable income. This amount is reported to a partner on Schedule K-1, a copy of which goes to the IRS. Whether the partner has received cash to go with that K-1 does not matter to the IRS. That is a matter for the partner to take up with the partnership.

I then see a court order in April 2023 releasing the husband from the matter.

That is unusual. What happened?

The IRS had not sent out a Notice of Deficiency – the 90-day letter – to the husband. This is a no-no. The IRS also has rules and procedures, and each spouse (on a joint return) must receive his or her own Notice of Deficiency. Mary received hers. He did not.

Now Mary was on her own.

Coincidentally, the partnership income went away.

COMMENT: It appears the husband owned the partnership.

We are back to Mary’s W-2 and social security.

Mary and the IRS worked on an agreement. There was no tax due for 2017. In fact, there was an overpayment of $284.

Mary wanted the $284.

Can’t blame her.

The IRS said no.

Mary in response refused to sign the agreement.

In March 2024 Mary filed a tax return for 2017. She wanted her refund.

What do you think: will Mary receive that refund?

Here is the relevant law:

Sec. 6511 Limitations on credit or refund

Period of limitation on filing claim. Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid. Claim for credit or refund of an overpayment of any tax imposed by this title which is required to be paid by means of a stamp shall be filed by the taxpayer within 3 years from the time the tax was paid.

Right or wrong, there is a limit on how long you can wait to file for a refund. If you file a return, for example, you have three years to amend for a refund.

There is a riff on the above rule if you file now and pay later. The Code will then permit a refund until 2 years after the tax is paid if that date is after the three-year date.

Notice what this three-and-two have in common:

          You filed a return.

If you do not file a return, the rule gets grimmer:

          You have until 2 years after the tax was paid.

If you file, you start with three and might move to two – and only if two allows for more time.

Don’t file and you have two – period. You have no choice.

Let’s see what Mary did:

·       Mary’s 2017 tax return was due April 15, 2018.

·       She did not file, so the mandatory two-year rule applies.

·       There is still hope, though. If she files within three years – by April 15, 2021 – she can flip the mandatory two back to the normal three-and-two.

o   She filed 2017 in March 2024.

Nope. Too late all around.

Mary had no tax due for 2017, but she likewise had no refund for 2017.

My thought? If you have withholding, consider filing even if there is no tax due. Why? Because withholding represents tax paid, and not filing triggers the mandatory two-year rule. By filing you move to the three-and-two rule. It may save you; it may not, but it provides more breathing room than the alternative.

Today we discussed Mary deNourie v Commissioner, U.S. Tax Court, docket 18182-22.

Tomato Supplier Must Change Accounting Method

 

Let’s talk about when we can deduct something on a tax return.

We are talking about accrual accounting. Cash accounting would be easy: you are not allowed to deduct something until it is paid.

Not surprisingly, there is a Code section for this.

Code § 461 - General rule for taxable year of deduction

            (h) Certain liabilities not incurred before economic performance

(1) In general

 

For purposes of this title, in determining whether an amount has been incurred with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.

We see two key terms: the all-events test and economic performance.

First, a potential deduction must pass the all-events test before it can even think of landing on a tax return.

Second, that potential deduction must next pass a second test – economic performance – before it is allowed as a deduction.

Let’s spend time today on the first hurdle: the all-events test.     

Back to the Code:

            All events test

For purposes of this subsection, the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.

There are two prongs there:

·       The fact  

·       The amount  

Much of the literature in this area concerns economic performance, which is the next test after the above two are met. One might presume that the all- events test is a low bar, and that an expense accrued under GAAP for financial reporting purposes would almost automatically meet the all-events test for tax reporting purposes.

You would be surprised how often this is not true, and tax accounting will not give the same answer as financial reporting accounting.

I was reviewing a case this past week. It comes from the Court of Appeals for the Ninth Circuit, a circuit which includes California.

Morning Star Packing Company and Liberty Packing Company appealed their Tax Court decisions. Both are based in California, and – combined – they supply approximately 40% of the U.S.’s tomato pastes and diced tomatoes. 

Tomato season in California lasts approximately 100 days – from June to September. During this period Morning Star runs its production facilities at maximum capacity 24 hours a day. When the season ends in October, the equipment has been traumatized and needs extensive reconditioning before going into production again. For assorted reasons, Morning Star normally waits near the start of the following season before doing such reconditioning.

Let’s assign dates so we can understand the tax issue.

Say that the frenetic 100-day production activity occurred in 2022.

Morning Star will recondition the equipment before the start of the next production cycle – that is, in 2023.

Reconditioning costs are substantial and can be north of $20 million.

Morning Star deducts the anticipated reconditioning costs to be incurred in 2023 on its 2022 tax return.

What do you think? Can Morning Star clear the all-events test?

Here is the taxpayer:

·       Our customers generally require that the tomato products meet certain quality and sanitary standards. Many customers require independent testing. The facilities are also inspected by the U.S. Department of Agriculture, the Food and Drug Administration and the California Department of Public Health.

·       An obligation to refurbish the equipment is strongly implied by the need to meet governmental regulations.

o   Failure to meet such standards could result in the company being required to pay farmers for spoiled tomatoes and/or paying customers for failure to provide tomato products. Any such payments could be catastrophic to the company.

·       The company has credit agreements with several banks. These agreements include numerous covenants such as the following:

o   Each borrower and its respective Subsidiaries shall (i) maintain all material licenses, Permits, governmental approvals, rights, privileges, and franchises reasonably necessary for the conduct of its business ….

o   Each borrower and its respective Subsidiaries shall … conduct its business activities in compliance with all laws and material contractual obligations applicable ….

o   Each borrower and its respective Subsidiaries shall …keep all property useful and necessary in its business in good working order and condition, ordinary wear and tear excepted….

·       An obligation to refurbish the equipment can be inferred from the “all property useful and necessary in its business in good working order” covenant.

Here is the IRS:

·       The credit agreements do not specifically fix the company’s obligation.

o   The agreements do not specify which laws or regulations must be complied with.

o   The agreements do not specify which property must be kept in good working order.

o   The term “wear and tear” refers to ordinary use; “ordinary” wear and tear is excepted; the agreements therefore do not require the company to refurbish its equipment because it would meet the “ordinary wear and tear” exception.

·       The customer agreements are production specific and do not directly require reconditioning costs. Granted, failure to perform could be financially catastrophic, which implies a high degree of certainty that reconditioning will occur, but a high likelihood is different from a certain obligation.

Both the Tax Court and the Appeals Court agreed with the IRS.

I am divided.

I believe that the IRS is technically correct. There was no explicit obligation, requirement, or guarantee that Morning Star will recondition its facilities before the start of the next season’s production run. I however consider that a false flag. Economic and business reality assures me that it will recondition, because a failure to do so could invite business and financial ruin. Would the USDA or FDA even allow them to start next year’s production run without reconditioning?

Decisions like this unfortunately pull tax practice closer to a wizard’s incantation. The practitioner must be certain to include the magic words, intonating appropriately at proper moments to evoke the intervention of unseen eldritch forces. Fail to include, intone, or evoke correctly and lose the spell – or tax deduction.

Here is Judge Bumatay’s dissent:

The Internal Revenue Service (“IRS”) has a shocking view of taxpayer’s money. According to the IRS’ counsel at oral argument, any disagreement on when a tax payment is due constitutes ‘an interest-free loan from the government' to the taxpayer. That’s completely wrong. Simply, the income of everyday Americans is not government property.”

In fact, Morning Star has used this method since its founding. And the IRS had endorsed this practice – it audited Morning Star in the early 1990s and concluded that this practice was acceptable. But now, after Morning Star’s deductions for years, the IRS changes its mind and demands that Morning Star alter how it recognizes the reconditioning costs.”

Morning Star’s liability was fixed at the end of each season’s production run.”

… the law does not require the taxpayer to prove the fixed obligation to a metaphysical certitude.”

You go, Judge B.

I am not impressed that the IRS previously looked at the accounting method, found it acceptable and now wants to change its mind. That is not the way it works in professional practice, folks. The CPA cannot be reviewing every possible accounting issue de novo every year.

And I am less than impressed that an IRS representative argued that the change was necessary because the government was assuming the risk that the company would not be able to pay its taxes should it encounter a bad harvest or other financial malady.

Seriously? The owners of Morning Star face multiple business dangers every day and the government is “assuming the risk?” We cannot DOGE these people and bureaucracies soon enough.

But then again, Morning Star could have boosted its case with a minor change to its credit agreements. How? Include annual reconditioning as a requirement to retain its credit facility. If Morning Star is going to recondition anyway, making it a requirement might be the magical incantation we need.

Our case this time is Morning Star Packing Company L.P., 9^th Circuit, No. 21-71191.