When is the accrual method available to taxpayers?
A recent Tax Court case addresses the accrual method of accounting in the cost-of-goods-sold (COGS) contexts:
The Morning Star Packing Company, L.P., et al. v. Comm’r, T.C. Memo. 2020-142 | October 14, 2020 | Cohen A. | Dkt. Nos. 5013-15, 5015-15, 16684-16, 16842-16
Short Summary: Petitioners sought review of the IRS’ determination that they were not entitled to increase their cost of goods sold (“COGS”) for the costs to restore, rebuild, recondition, and retest their manufacturing facilities for years of 2008 – 2011. The Tax Court found in favor of the IRS.
Key Issue: Two key issues: (1) were certain accrued production costs fixed and binding where economic performance did not occur until the year following the tax year claimed for those costs; and (2) did Petitioners’ inclusion of such production costs in COGS for the years in issue result in a more proper match against income than inclusion in the taxable year.
- A taxpayer reporting on the overall accrual method of accounting must generally demonstrate two items in order to be able to claim a deduction on the current year’s return: (1) economic performance with regard to the item in question; and (2) all events have occurred that determine the fact of a liability and the amount of that liability can be determined with reasonable accuracy.
Key Points of Law:
- IRC § 461(a) provides that a deduction must be taken for the proper taxable year under the taxpayer’s method of accounting. Generally, an accrual method taxpayer may deduct expenses for the years in which the taxpayer incurred the expenses, regardless of the actual payment dates. See IRC § 461(h)(4); Caltex Oil Venture v. Commissioner, 138 T.C. 18, 23 (2012); 26 CFR § 1.461-1(a)(2).
- The all events test governs whether a business expense has been incurred to permit its accrual for tax purposes. See Challenge Publ’ns, Inc. v. Commissioner, T.C. Memo. 1986-36, 1986 Tax Ct. Memo LEXIS 570, at*22, aff’d, 845 F.2d1541 (9th Cir. 1988).
- Liability is incurred under the all events test if three factors are met: (1) all of the events that establish the fact of the liability must have occurred, (2) the amount must be able to be determined with reasonable accuracy, and (3) economic performance must have occurred. See IRC § 461(h)(4); See also 26 CFR §§ 1.461-1(a)(2), 1.461-4.
- The term “liability” refers to “any item allowable as a deduction, cost, or expense for Federal income tax purposes.” See 26 CFR § 1.446-1(c)(1)(ii)(B).
- To be deductible, a liability must be fixed, absolute, see Brown v. Helvering, 291 U.S. 193, 201 (1934), and unconditional, see Lucas v. N. Tex. Lumber Co., 281 U.S. 11, 13(1930).
- A liability may not be deducted if it is contingent upon the occurrence of a future event. See Lucas v. Am. Code Co., 280 U.S. 445, 452 (1930).
- Generally, the fact of a liability is established on the earlier of: (1) the event fixing the liability, such as the required performance or (2) the date the payment is unconditionally due.” See VECO Corp. & Subs. v. Commissioner, 141 T.C. 440, 461 (2013).
- Obligations created by separate contracts, statutes, or regulations may qualify as deductible liabilities for Federal income tax purposes. See Exxon Mobil Corp. v. Commissioner, 114T.C. 293, 318-319 (2000); Ohio River Collieries Co. v. Commissioner, 77T.C. 1369, 1370-1371(1981). In such cases the contracts and statutes must clearly set forth the taxpayer’s obligations to “provide a sufficiently fixed and definite basis on which to base the tax accruals sought.” See Exxon Mobil Corp. v. Commissioner, 114 T.C. at 317-318.
Insight: This case highlights the need for an accrual taxpayer to give extra scrutiny to the liabilities that it intends to deduct to ensure that all conditions have been met to claim the deduction. It further illustrates the need for taxpayers to engage and consult with tax professionals in the preparation of their tax returns.
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