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
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., 9th Circuit, No. 21-71191.
No comments:
Post a Comment