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.

Losing A Casualty Loss

 

I have stayed away from talking about casualty losses.

To be fair, one needs to distinguish business casualty losses from personal casualty losses. Business casualties are still deductible under the Code. Personal casualties are not. This change occurred with the Tax Cut and Jobs Act of 2017 and is tax law until 2025, when much of it expires.

This is the tax law that did away with office-in-home deductions, for example. Great timing given that COVID would soon have multitudes working from home.

It also did away with personal casualty losses, with an exception for presidentially - declared disaster areas.

Have someone steal your personal laptop. No casualty loss. Accident with your personal car? No casualty loss. Lost your house during the storms and tornados in western Tennessee at the end of March 2023? That would be a casualty loss because there was a presidential declaration.

I consider it terrible tax law, but Congress was primarily concerned about finding money.  

I am reading a case that involves casualty losses. Two, in fact. The Court included several humorous flourishes in its decision.

Let’s go over it.

Thomas Richey and his wife Maureen Cleary bought a second home in Stone Harbor on Cape May in the south of New Jersey. The house was on the waterfront with access to the open ocean. They also bought a 40-foot boat.

Sounds nice.

In 2017 storm Stella hit.

Richey and Cleary claimed casualty losses totaling over $820,000 on their 2017 tax return.

That will catch attention.

Here is the Court:

Such a large loss - one that caused them to reduce their adjusted gross income of more than $850,000 to a taxable income of zero – bobbed into the Commissioner’s view, and he selected their return for audit.”

The Commissioner did more than select the return; he denied the casualty loss deduction altogether.

Richey and Cleary petitioned the Tax Court.

Yep. Had to.

Whereas they lived in Maryland (remember: New Jersey was their second home), they petitioned the Court for trial in Los Angeles.

I do not get the why. Very little upside. Possible massive downside.

We added the case to one of our trial calendars for Los Angeles, but on the first day of that session neither petitioner showed up.”

Uh, Richey …?!

We postponed trial for a day to enable Richey to testify via Zoom.”

Richey explained that he learned about the trial only a week before, and even then, no one gave him specific details.

We do not find this credible ….”

This could have started better. 

The couple’s case began taking on water right at the start…”

The Court seemed amused.

Back to business, Richey. Let’s first establish that a casualty occurred.

He testified that he had taken pictures of the damage to both boat and home on his phone shortly after the storm.”

Good.

He explained, however, that a later software update to his phone deleted them.”

Seriously?

That left him to introduce only photographs of the house taken … nearly a year after the storm hit and after reconstruction had already begun.”

A year? Were you that busy?

These photographs depict no visible damage other than that which one might see at any construction site, and we could see nothing that showed damage that we could specifically attribute to the storm. “

Richey, I have a question for you.

… we did not find Richey’s testimony, standing alone, credible on this point.”

Have you seen John Wick?

As for the boat, the couple introduces a photograph of what the boat looked like before the storm, but nothing to show what it looked like afterwards. The couple also gave us no receipts for any boat repairs.”

Tell me the truth: did you do something to this judge’s dog?

Whom are we to believe?”

Richey, this is legal-speak for “we do not believe you.”

OK, we are going to have to lean double hard on the appraisals. Those involve third parties, so maybe we can get the Court to back off a bit.

Richey and Cleary did not get an appraisal of their own home valuing it before and after the storm.”

And may I ask why, Richey?

Richey instead consulted a real-estate agent who provided them with Multiple Listing Service (MLS) printouts of other people’s homes. This is a problem for many different reasons.”

You think?

The first … is that he didn’t talk to this agent until after the audit had begun.”

I have an idea, Richey, but it’s a long shot.

It is not impossible for a homeowner to conduct an appraisal himself …”

Richey, go improv. You live in Cape May. You know the prices. You know the damage the storm wrought. Make the Court believe you. Sell it.

They also produced no evidence of their awareness of market conditions in Stone Harbor. What we got were photographs of MLS printouts.”

You are a man of commitment and sheer will, Richey.

We infer from Richey’s having to reach out to an agent to give him such comparables an unspoken admission that he is not qualified to conduct an adequate appraisal on his own.”

I am familiar with the parlance, Richey.

If the absence of proof of damage causes the couple’s case to founder, the absence of proof on valuing that damage causes it to sink altogether.”

Well, that’s that. Maybe we can get something on the boat.

Richey and Cleary fare no better on the loss they claim for their boat.”

Richey, walk out of here with your pride intact.

All these attacks by the Commissioner have picked completely clean the flesh of their claimed deduction.”

Richey, just walk out of here.

Richey’s first mistake was scheduling a Tax Court hearing in Los Angeles. That led to the disastrous failure-to-show, which clearly angered the Court. The Court felt they were being lied to, and they never relented. The lack of an appraisal – while not necessarily having to be fatal – was fatal in this case. Richey was unable to persuade the Court that he had the experience or expertise to substitute for an appraisal.    

Sometimes the Court will carry water for a petitioner who is underprepared. We have reviewed a couple of these cases before, but that beneficent result presupposes the Court likes the person. That was not a factor here.

Our case this time was Richey and Cleary v Commissioner, T.C. Memo 2023-43.

If I Had A Pony, I Would Ride It On My (Tug) Boat

If you have a business, and especially if that business has real estate, odds are very good that your tax advisor will talk to you about the “repair regulations” this filing season.

The IRS and taxpayers have spent decades arguing and going to court over whether an expenditure is a repair (and immediately deductible) or a capital improvement (which cannot be deducted immediately but rather must be depreciated over time). Eventually the IRS decided to pull back, review the existing court cases and develop some rhyme or reason for tax practice in this area. They were at it for years and years.

And now we have the “repair regulations.”

I debated whether to write on this topic, as one can leave the pavement and get lost in the weeds very quickly. It is like a romper room for tax nerds. Still, we have to at least discuss the high points.

Let’s set this up. Say that you have a tug boat. The boat is expected to last you approximately 40 years, if you maintain and keep it up. Every 4 or so years, you anchor the tug and give it a good overhaul, replace what needs replacing and rebuild the engine. This is going to cost you well over $100 grand.

Question: is this a repair (hence deductible) or a capital improvement (not immediately deductible but depreciable over time)?

It is not immediately clear. This costs a lot of money, so one’s first response is that it has to be capitalized and depreciated. However, regular use of a tug presumes heavy maintenance of this kind over its life. That sounds more like a repair expense.

The IRS has introduced the concept of a unit of property. We have to base the repair versus capitalization decision on the unit of property. Is the engine the unit of property (UOP) or is it the overall boat?

The main test for UOP is “functional interdependence.” The placing in service of one thing depends on the placing in service of something else.

Well, a tug boat engine without a tug boat to put it in is not of much use to anybody, so we would say that the overall boat is the unit of property.

Progress. Do we now know whether to capitalize or deduct the engine?

Nope.

Onward.

We next climb through a fence we will call the “BAR,” which stands for

·        Betterment

·        Adaptation

·        Restoration

If you get stuck on any rung of the “BAR,” you have to capitalize the cost. Sorry.

Let’s have a quick peek at which each term means:

·        Betterment

o   You made the thing larger, stronger, more efficient.

We did not turn the thing into a “monster” tug. Let’s move on.

·        Adaptation

o   You tweaked the thing for a different use or purpose.

Nope. It’s still a tug. Can’t fly it or drive it on a highway.

·        Restoration

o   Returning the thing to a usable condition after you have run it into the ground, either because you neglected it (and it fell apart) or it just got too old.      

Doesn’t sound like it. We are not neglecting the tug in any way, and it still has many years of use left.

This is looking pretty good for our tug.

Let’s go through a few more rules, just in case.

If your CPA prepares audited financial statements for you, the IRS will not challenge your deducting something up to $5,000 as a repair as long as you did the same thing on your financial statements.  

That tug thing costs way more than $5,000. Let’s continue. 

NOTE: BTW, if you do not have an audit, the IRS drops that dollar limit down to $500.

If we are talking about “materials and supplies,” the IRS will not challenge your deducting something as long as it costs $200 or less. Fuel for that tug would be considered “materials and supplies.” 

That tug work blew past $200 like it was standing still. Let’s proceed.

If you capitalize the thing on your books and records, the IRS will not argue that you should have deducted it instead.

            Downright charitable of them. Let’s move on.

If a repair is expected to be done more than once over the life of the UOP, then the IRS will not challenge your deducting it as a repair.

Whoa. We have something here. That boat is expected to last somewhere around four decades. The heavy maintenance has to be done every so many service hours, generally meaning every three or four years. Looks like we can deduct the repairs to our tug.

Let’s dock the tugboat and briefly discuss a building. Perhaps we can see our tug from our building.

The IRS is taking the position that a building is both one unit of property and more than one unit of property.

I do not make this up, folks.

The IRS wants certain systems of a building – like its HVAC or its elevators – to also be considered a separate UOP. Let’s take an example. Let’s say that you are replacing a bunch of windows on that building. You would then evaluate whether it is a repair or an improvement by reference to the building as a whole. This is a good thing, as it would take a lot to “improve” the building as a whole. This makes it more likely that the answer will be a deductible repair.

However, say that you replace an elevator. The IRS says that you have to look at elevators separately from the overall building. We’ll, it does not take much to improve an elevator if you are just comparing it to an elevator. This is a bad thing, as it makes it more likely that the result will be a capital improvement.

BTW there is a separate test if your building costs less than a $1 million when you bought it. The IRS will “spot” you a certain amount before it will challenge whether something is a repair or not. It’s for the smaller landlords, but it is something.

And there you have the highlights of the repair regulations.

Depending on your fact patterns, there may be elections and forms that you have to attach to your tax return. Your tax advisor may even request that you change your underlying bookkeeping – like expensing stuff under $5000/$500 on your general ledger, for example. Some of these will require extra work, and hence additional fees, by and from your advisor.

And there is one more thing.

Let’s go back to the tugboat.

Let’s say that you did the major overhaul four years ago and capitalized the cost. You are now deducting those repairs over time as depreciation. The new rules now allow you to deduct the cost immediately as a repair. Had we only known!

Is it too late for us? Four years back is one more year than the statute of limitations permits, so we cannot go back and amend your return.

The IRS – to their credit – realized the unfairness of this situation, and it will let you go back and apply these new rules to that old tax year. The IRS calls it a “partial disposition,” and you can deduct what’s left of that capitalized tugboat repair on your 2014 tax return. It is called a “Change in Accounting Method” and is yet another multi-page form with your return, but at least you can get the deduction. But only on 2014. Let it slip a year and you can forget about it.

If any of the above rings a bell, please discuss the “repair regulations” with your tax advisor. Seriously, after 2014 you may be stuck. Tax does not have to be fair.

Lyle Lovett - If I Had A Boat 

Do You Actually Need To Rent Before Deducting Rental Expenses?

Let’s say that you own a piece of property. You are trying to claim a rental loss from that property on your tax return. What would you say is the most important requisite in order to claim that loss?

Let’s take a look at the Meinhardt case.

Mr. Meinhardt worked full-time as an architect. His wife operated a day care center out of their home.

In 1976 they purchased 140 acres of farmland in rural Minnesota, consisting of tillable and pasture land and an eighty-year old farmhouse in need of substantial renovation. In subsequent years they sometimes farmed the land, but mostly they rented the land to neighbors for cash rent. They were successful in renting the farmland. They were not so successful in renting the farmhouse.

Thirty years go by.

On their tax returns for 2005, 2006 and 2007 they reported rent from the farmland, as well as substantial expenses for repairs to the old farmhouse. The IRS looked at the return and disallowed the repairs.

They wound up in Tax Court.

The Meinhardts had a simple argument: hey, we own a farm. We rent the farm. For the years under audit our expenses exceeded our income, and we therefore incurred farm losses.

The IRS had a different take. They saw the land being rented on a regular and repetitive basis. There wasn’t much for the IRS to challenge there.

The farmhouse was a different matter. The farmhouse never reported rental income.

That is one lousy rental.

Let’s take a breath. This is not necessarily fatal. The Meinhardts rented a farm. It doesn’t means that all parts and parcels of said farm were equally profitable. As long as it was profitable overall, right?

That, by the way, is the tax concept of aggregation when discussing passive activities, such as rentals.

The Meinhardts explained that they tried to rent the farmhouse, but nobody wanted it. They placed ads in newspapers, put up notices in local stores and spread the word that the house was for rent. The best they could get were renters who would barter for their rent, trading repairs in order to live rent-free. You cannot rent something that no one wants to rent. That doesn’t mean it wasn’t legitimately for rent, though.

The Meinhardts had a reasonable argument.

The IRS, on the other hand, felt that the farmhouse should be separated from the farmland. Hey, they tried to rent the house separate from the land. They rented the land but never rented the house. Does that sound like one rental or two rentals to you?

And there you have the tax concept of disaggregation.

Rent is rent, whether it be land or building. How was the IRS going to pull this off?

The Meinhardts helped them by never reporting rental income from the farmhouse. There was barter, but the documentation was sketchy.

Since the house had not been rented, the IRS wanted to know who had used the house over the years. The Meinhardts used it themselves, but only sporadically and usually coinciding with maintaining the property.

Other tenants included:

·        Wife’s brother (lived their seasonally)

·        Their daughter and son-in-law

·        Their son and his family

It turns out that the Meinhardts – or their family – had used the farmhouse for almost all the years.

Are you kidding me?

Did I mention that the 2005 through 2007 years were not representative, as the Meinhardts were racking up a lot of repairs to that old house? It sure would be nice to slide those expenses over to Uncle Sam.

The Tax Court decided that the farmhouse was either the Meinhardts second residence or it was a property not held for rental – you take your pick. The tax consequence is the same.

The Meinhardts, unhappy with this result, appealed to the Eight Circuit. They lost there too.

What are we to learn from this? That the Meinhardts should never have tried to rent the farmhouse separate from the farmland? That they should have automatically thrown in the farmhouse for a dollar when renting the land? That they never should have allowed the family to stay there? That at least they should have charged the family rent? (I personally think that last one is obvious).

I think we are thinking about this too hard.

Methinks that what the court could not stomach was the Meinhardts selling their house in the suburbs and moving into the farmhouse in 2010.

After fixing it up in 2005, 2006 and 2007.

And deducting it on their tax return.

Courts will “back into” a tax analysis to get the desired result. Happens all the time.

The Meinhardts failed to observe a fundamental tenet of tax strategy: never arm the other side.