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.

FICA Tax On Nonqualified Deferred Compensation

 

One of the accountants brought me what she considered an unusual W-2.

Using accounting slang, Form W-2 box 1 income is the number you include on your income tax return. Box 3 income is the amount on which you paid social security tax.  There often is a difference. A common reason is a 401(k) deferral – you pay social security tax but not income tax on the 401(k) contribution.

She had seen fact pattern that a thousand times. What caught her eye was that the difference between box 1 and box 3 income was much too large to just be a 401(k). 

Enter the world of nonqualified deferred compensation.

What is it?

Let’s analyze the term backwards:

·      It is compensation, meaning that there is (or was) an employment relationship.

·      There is a lag in the payment. It might be that the employee wants the lag; it might be that the employer wants the lag. A common example of the latter is a handcuff: the employee gets a bonus for remaining with the company a while.

·       The arrangement does not meet the requirements of standardized deferred compensation plans, such as a profit-sharing or 401(k) plan. You have one of those and tax Code requires to you include certain things and exclude others. That standardization is what makes the plan “qualified.”

A common type of nonqual (yep, that is what we call it) is a SERP – supplemental executive retirement plan. Get to be a big cheese at a big company (think Proctor & Gamble or FedEx) and you probably have a SERP as part of your compensation package.

I wish I had those problems. Not a big company. Not a big cheese.

Let’s give our mister big cheese a name: Gouda.

Gouda has a nonqual.

The taxation of a nonqual is a bit nonintuitive: the FICA taxation does not necessarily coincide with its income taxation.

Let’s run through an example. Gouda has a SERP. It vests at one point in time- say 5 years from now. It will not however be paid until Gouda retires or otherwise separates from service.

Unless something goes horribly wrong. Gouda does not have income tax until he receives the money. That might be 5 years from now or it might be 20 years.

Makes sense.

The FICA tax is based on a different trigger: when does Gouda have a right to the money?

Think of it like this: when can Gouda sue if the company fails to pay him? That is the moment Gouda “vests” in the SERP. He has a right to the money and – barring the exceptional – he cannot be stripped of this right.

In our example, Gouda vests in 5 years.

Gouda will pay social security and Medicare (that is, FICA) tax in 5 years.

It is what sets up the weird-looking Form W-2. Let’s say the deferred compensation is $100 grand. The accountant is looking at a W-2 where box 3 income is (at least) $100 grand higher than box 1 income (remember: box 1 is income tax and Gouda will not pay income tax until gets the money).

There is even a name for this accounting: the “Special Timing Rule.”

Why does this rule exist?

You know why: the government wants its money - at least some of it.

But if you think about it, the special timing rule can be beneficial to the employee. Say that Gouda is drawing a nice paycheck: $400 grand. The social security wage base for 2020 is $137,700. Gouda is way past paying the full-boat 7.65% FICA tax. He is paying only the Medicare portion of the FICA - which is 1.45%. If the IRS waited until he retired, odds are the Gouda would not be working and would therefore have to pay the full-boat 7.65% (up to the wage limit, whatever that amount is at the time).

Can Gouda get stiffed by the special timing rule?

Oh yes.

Let’s look at the Koopman v United States case.

Mr Koopman retired from United Airlines in 2001. He paid FICA tax (pursuant to the special timing rule) on approximately $415 grand.

In 2002 United Airlines filed for bankruptcy.

It took a few years to shake out, but Mr Koopman finally received approximately $248 grand of what United had promised him.

This being a tax blog, you know there is a tax hook somewhere in there.

Mr Koopman wanted the excess FICA he had paid. He paid FICA on $415 grand but received only $248 grand.

In 2007 Koopman filed a refund claim for that excess FICA.

Does he have a chance?

Mr Koopman lost, but he did not lose because of the general rule or special rule or any of that. He lost for the most basic of tax reasons: one only has 3 years (usually) to amend a return and request a refund. He filed his refund request in 2007 – much more than 3 years after his withholdings in 2001.

Is there something Koopman could have done?

Yes, but he still could not wait until 2007. He would have had to do it by 2004 – the magic three years.

What could he have done?

File a protective refund claim.

I do not believe we have talked before about protective claims. It is a specialized technique, and an accountant can go a career and never file one.

I believe we have a near-future blog topic here. Let me see if I can find a case involving protective claims that you might want to read and I would want to write.

When Does A Grocery Store Get To Deduct the Fuel Points You Receive?

There is a grocery store chain that my wife uses on a regular basis. They have a gasoline-discount program, whereby amounts spent on purchasing groceries go toward price discounts on the purchase of gasoline. As the gas stations are adjacent to the grocery store, it is a convenient perk.

I admit I used the discount all the time. I purchased a luxury car this year, however, and my mechanic has advised me not to use their gasoline. It sounds a bit over the top, but until I learn otherwise I am purchasing gasoline elsewhere. My wife however continues as a regular customer.

Giant Eagle is a grocery store chain headquartered out of Pittsburgh. They have locations In Pennsylvania, Ohio, West Virginia and Maryland. They have a similar fuel perk program, except that their gasoline station is called “GetGo” and their fuel points are called “fuelperks!”

Their fuelperks! operate a bit differently, though. The perks expire after three months, and they reduce the price of the fuel to the extent possible. I suppose it is possible that they could reduce the price to zero. My fuel points reduce the price of a gallon by 10-cent increments, up to a ceiling. I am not going to get to zero.

Giant Eagle found itself in Tax Court over its 2006 and 2007 tax returns. The IRS was questioning a deduction on its consolidated tax return: the accrued liability for those fuelperks! at year-end. The liabilities were formidable, amounting to $6.1 million and $1.1 million for 2006 and 2007, respectively. Multiply that by a corporate tax rate of 34% and there are real dollars at stake.

What are they arguing over?

To answer that, let’s step back for a moment and talk about methods of accounting. There are two broad overall methods: the cash method and the accrual method. The cash method is easy to understand: one has income upon receiving money and has deductions upon spending money. There are tweaks for uncashed checks, credit cards and so forth, but the concept is intuitive.

The accrual method is not based on receiving or disbursing cash at all. Rather, one has income when monies are due from sale of product or for performance of services. That is, one has income when one has a “receivable” from a customer or client. Conversely one has a deduction when one owes someone for the provision of product or services. That is, one has a “payable” to a vendor, government agency or employee.

If one has inventories, one has to use the accrual method for tax purposes. Take a grocery store – which is nothing but inventory – and Giant Eagle is filing an accrual-basis tax return. There is no choice on that one.

There are additional and restrictive tax rules that are placed on “payables” before one is allowed to deduct them on a tax return. These are the “all events” rules, are found in IRC Section 461(h), and have three parts:

·        Liability must be fixed as of year end

·        Liability must be determined with reasonable accuracy

·        Economic performance must occur

Why all this?

Congress was concerned that accrual taxpayers could “make up” deductions willy-nilly absent more stringent rules. For example, a grocery store could argue that its coolers were continuously wearing out, so a deduction for a “reserve” to replace the coolers would be appropriate. Take the concept, multiply it by endless fact patterns and – unfortunately – Congress was probably right.

All parties would agree that Giant Eagle has a liability at year-end for those fuel points. Rest assured that the financials statement auditors are not have any qualms about showing the liability. The question becomes: does that liability on the financial statements rise to the level of a deduction on the tax return?

You ever wonder what people are talking about when they refer to a company’s financial statements and tax return and say that there are “two sets of books?” Here is but a small example of how that happens, and it happens because Congress made it happen. There are almost endless examples throughout the tax Code.

The IRS is adamant that Giant Eagle has not met the first requirement: the “liability must be fixed.”

To a non-tax person, that must sound like lunacy. Giant Eagle has tens of thousands of customers throughout multiple states, racking up tons of fuel discount points for the purchase of gasoline at – how convenient – gasoline stations right next to the store. What does the IRS think that people are going to do with those points? Put them on eBay? If that isn’t a liability then the pope is not Catholic.

But consider this…

The points expire after three months. There is no guarantee that they are going to be used.

OK, you say, but that does not mean that there isn’t a liability. It just means that we are discussing how much the liability is. The existence of the liability is given.

COMMENT: Say, you have potential as a tax person, you know that?

That is not what the IRS was arguing. Instead they were arguing that the liability was not “fixed,” meaning that all the facts to establish the liability were not in.

How could all the facts not be in? The auditors are going to put a liability on the year-end audited financial statements. What more do you want?

The IRS reminds you that it refuses to be bound by financial statement generally-accepted-accounting-principles accounting. Its mission is to raise and collect money, not necessarily to measure things the way the SEC would require in a set of audited financial statements in order for you not to go to jail. In fact, if you were to release financial statements using IRS-approved accounting you would probably have serious issues with the SEC.

OK, IRS, what “fact” is missing?

The customer has to return. To the gasoline station. And buy gasoline. And enough gasoline to zero-out the fuel points. Until then all the facts are not in.

Another way of saying it is that there is a condition precedent to the redemption of the fuel points: the purchase of gasoline. Test (1) of Sec 469(h) does not allow for any conditions subsequent to the liability in order to claim the tax deduction, and unfortunately Giant Eagle has a condition subsequent. No deduction for you!

Mind you the deduction is not lost forever. It is delayed until the following year, because (surely) by the following year all the facts are in to establish the liability. The effect is to put a one-year delay on the liability: in 2008 Giant Eagle would deduct the 12/31/2007 liability; in 2009 it would deduct the 12/31/2008 liability, and so on.

And the government gets its money a year early. It is a payday-lender mentality, but there you are.

BTW test (1) is not even the difficult part of Section 469(h). That honor is reserved for test (3): the economic performance test. Some day we will talk about it, but not today. That one does get bizarre.

Related Party and Tax Deductions

If you are a partnership, LLC or S corporation and report on the accrual basis, this may apply to you.

You may be aware that there are restrictions on deductions between related accrual-basis and cash-basis entities or individuals. These are the “related party” rules of IRC Section 267 and are well-known to tax accountants. By the way, these rules drive on a one-way street: the effect is to delay the deduction, not to delay the income.

                EXAMPLE ONE:

Sanctuary, Inc is a C Corporation and accrual-basis taxpayer. It owes $34,000 at year-end to Sam (a Schedule C) for the provision of goods or services. Sam is a 51% shareholder.  Sam is on the cash-basis, as most individuals are. Sanctuary, Inc cannot deduct the $34,000 until Sam includes it in income, because more-than-50% ownership triggers the related party rule.

                EXAMPLE TWO:

Sam (a Schedule C) owes Sanctuary, Inc $27,000 at year-end for the provision of goods or services.  Sam (a Schedule C) cannot deduct this until it makes payment. Sam (a Schedule C) is, after all, on the cash-basis. Sanctuary, Inc is quite unruffled by all this. As an accrual-basis entity, it will report the $27,000 in income without waiting for Sam’s (a Schedule C) deduction.

The trap here is the more-than-50 percent rule. The 50% requirement goes away if the transaction is between an S corporation, partnership/LLC and a shareholder or partner/member.

Change Sanctuary to a partnership, LLC or S corporation and the threshold drops to any ownership. As an example, an accrual to a 2-percent S- corporation shareholder would be disallowed under the related party rules.

Why? Here is how I make sense of it. As a pass-through investor, both sets of numbers will wind up on one income tax return. The IRS is therefore stricter than it would be if the numbers wound up on two tax returns, such as between a C corporation and an individual.