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.

The New InvestOhio State Tax Credit

The recent Ohio biennial budget bill included an income tax credit for investments in qualifying small businesses.  This was a late addition, and it was made in response to some rather depressing statistics about Ohio business over the last decade:

·         Ohio has lost more jobs than any state other than California and Michigan

·         Ohio has ranked in  the bottom 10 states for population growth

·         Ohio’s economy has ranked in the bottom 5 states

The new tax credit is referred to as “Invest Ohio.” The credit will run for two years (Ohio has biennial budgets), and the state estimates that the program will cost $100 million. The state hopes to stimulate at least 30,000 jobs, at which number the state anticipates to breakeven.

The credit is nonrefundable. You need to have an Ohio income tax to make this worthwhile.

Let’s go through the steps:

(1)    This is an income tax credit. More specifically, only taxpayers with income taxes will be able to use it. You may recall that Ohio C corporations pay a Commercial Activity Tax (or “CAT”) in lieu of income taxes, so this credit is not for C corporations. Rather it is for individuals, passthroughs, trusts and estates.

(2)    You have to be an eligible small business.

a.       Your total assets are $50 million or less OR your total sales are $10 million or less

                                                               i.      Because of the “or,” you must meet one of the two tests to qualify.

b.      You must have enough presence in Ohio to qualify. There are two alternative tests:

                                                               i.       More than half your employees are in Ohio.

1.       It doesn’t matter how many employees you have. Just one (yourself) is enough.

                                                             ii.      You have more than 50 full-time equivalent employees in Ohio.

1.       This does not need to be more than half.

NOTE: Let’s go over this, as it may not be clear. If you have 2 employees and both are in Ohio, you qualify. If you have 274 employees, of which more than 50 are in Ohio, you qualify. Technically, this second test is done by full-time equivalents rather than employees, but you get the idea.

(3)    Fresh money is going into the business as equity.

a.       This fresh money is going to acquire, increase or maintain an equity interest.

                                                               i.      You are not playing banker here. This is not a “Loan from Owner.”

                                                             ii.      You are receiving shares, units – something- that indicate ownership.

                                                            iii.      An easy example is someone who becomes a new shareholder in an S corporation by investing $25,000. This is fresh money and he/she has acquired an ownership interest.

1.       What is you already own 100%? You cannot go over 100%.

a.       Answer:  this will count.

(4)    You have to spend the money in an approved way.

a.       You have to buy tangible personal property.

                                                               i.      Desks, a copier, computer monitors or a business van will qualify.

b.      You can buy real property, as long as it is in Ohio. Ohio will not subsidize that Florida condo.

c.       You can buy intangibles, such as patents, copyrights or trademarks.

                                                               i.      The one that occurred to me was enterprise software or a website.

d.      Compensation for new or retrained employees for whom the business is required to withhold Ohio income tax.

                                                               i.      I am not sure my firm has clients that would incur employee “retraining.”

                                                             ii.      A new employee will count.

1.       There is a big EXCEPT here: the employee cannot be an owner, manager or officer.

                                                            iii.      The Ohio tax withholding becomes an issue for the border residents. For example, I live in northern Kentucky but work in Cincinnati. I do not have Ohio withholding because of the reciprocal tax agreement.  As I read this, I would not qualify.

(5)    You have to spend this new money within six months.

(6)    The credit is 10 percent.

a.       There is a maximum however.

                                                               i.      The maximum credit is $1,000,000 per taxpayer.

1.       If you are married, this becomes $2 million.

b.      My understanding is that this $1 million limit is for the first credit period, which is two years. If the credit is renewed, my understanding is that you will get a brand new $1 million limit.

(7)    Tax credit period

a.       The first period of the program runs from 7/1/2011 to 6/30/2013 (remember: biennial budget).

b.      The timing of this credit is odd.

                                                               i.      You have to wait until the period is up (6/30/13) before you can claim the credit.

1.       So an investment in 2011 gets no payoff until 2013.

2.       At least you can use it in the same year the period expires.

c.       You then get 7 years to use up the credit. More specifically, an investment in 2011 would get to use its credit in tax years 2013 to 2019.

d.      IF THE PROGRAM IS CONTINUED IN 2013 …

                                                               i.      Then the waiting period becomes five years rather than two. That is a long time to it for a credit to kick-in. An investment in 2014 would have to wait until 2019 before using the credit.

(8)    You have to keep the money invested for the credit qualifying period.

a.       That is, you cannot put money in and take it right back out.

b.      But, then again, the first period is only two years. This is not a long time.

(9)    Paperwork

a.       There is paperwork for …

                                                               i.      The application and qualification,

                                                             ii.      The certification, and

                                                            iii.      A pledge not to dispose of the investment before the end of the holding period

b.      In short, the business and its owner will have paperwork. This makes sense, as Ohio wants (at a minimum) to keep track of how many people are using the program.

c.       The program is being administered by the Ohio Department of Development. They are your contact, not the Department of Taxation.

(10) Owners of passthrough entities will claim the credit based on their distributive or proportionate share of the entity.

Rick Kruse and I agree that the key point to this credit is the fresh cash. Perhaps the cash is funded by savings, by borrowings, or perhaps by a circular transaction, but somehow new money has to enter the picture. The problem may be getting the fresh cash in the owner’s name.

Think about the following examples:

(1)               The S corporation buys a truck. There is a down payment and a term note for the balance. Even if the shareholders sign on the note, there has been no fresh cash into the business, so there would be no tax credit.

(2)               The LLC wants to buy shop equipment. There are three members. Only one of the members is willing (or able) to start the required “fresh cash” sequence.  Perhaps he/she is the only one with enough savings, enough credit or enough collateral to borrow.  Therefore, only one of the members can initiate the “fresh cash” cycle. This situation may be more about member dynamics than tax planning.

(3)               The partnership constructs a building. The construction loan is signed by the partners. Under this loan, the draws are disbursed directly by the bank to the contractors and suppliers.  Whereas one can argue “fresh cash,” there has been no increase in equity. There has been only an increase in debt.  

Here is one that intrigues me:

(4)               A key employee is awarded 50 shares under a stock bonus program. The stock vests, so the employee recognizes taxable income on his/her personal return. The business in turn purchases equipment within the requisite six month period. Do we have a "fresh cash” cycle?

BTW, the instructions and directions for this credit are virtually nonexistent as I write this. For the time being there are questions with no answers. For example, can one set up a new company in order to qualify as an “eligible small business” or will the new company being aggregated with an existing company?  This is a basic technique – and therefore a basic question - for any tax practitioner.

If your business qualifies as an Ohio eligible small business, you simply must consider this credit in your tax planning. If you will be buying equipment, or trucks, or software, or hiring ANYWAY, why not plan for the credit? If you can’t make it work then you can’t, but at least consider it.