Inconsistent Reporting and Failure to Meet All-Events Test Precludes Accelerated Deductions. (Parker Tax Publishing December 07, 2013)

Taxpayers often try to accelerate deductions for tax purposes to obtain the tax benefits such deductions provide. If the taxpayer meets certain tests, accelerated deductions are appropriate. In VECO Corporation & Subs. v. Comm'r, 141 T.C. No. 14 (11/20/13), the taxpayer implemented a proposed change in accounting method and in so doing accelerated deductions for certain liabilities attributable to periods after the close of the tax year. The company claimed it was entitled to accelerate the deductions under the all-events test and/or the recurring item exception to the economic performance rules. However, for financial statement purposes, the taxpayer accrued the liabilities over more than one tax year. The Tax Court disallowed the accelerated deductions because (1) neither the required performances nor the payment due dates with respect to the majority of the deductions occurred before the close of the year, and (2) the liabilities were treated inconsistently for financial and tax purposes and were material items for tax purposes.

Background

VECO Corporation is the common parent of an affiliated group of corporations engaged in multiple businesses, such as oil and gas field services, newspaper publishing, manufacturing, construction, equipment rental, wholesale sales, leasing, and engineering. For its fiscal year ending (FYE) March 31, 2005, and certain prior years, VECO entered into a number of service contracts, licensing contracts, insurance contracts, and real property and equipment leases.

On its FYE 2005 tax return, VECO reported total income of over $71 million and claimed total deductions of more than $64 million. VECO also attached to its return a Form 3115, Application for Change in Accounting Method. VECO reported on an attachment to the Form 3115 that it was currently deducting liabilities as follows: (1) With respect to liabilities for which economic performance was satisfied by payment, VECO capitalized the liability and amortized the payment over the life of the agreement; (2) with respect to liabilities for which economic performance was not satisfied by payment, VECO deducted the liabilities in the period to which they related.

VECO proposed a change in its accounting method to: (1) deduct liabilities in the year incurred under the all-events test, with modifications under the recurring item exception for insurance and maintenance agreement payments; and (2) with respect to rent liabilities for which economic performance was not satisfied by payment, deduct those liabilities in the year the liabilities were fixed and determinable with reasonable accuracy, and where economic performance had occurred. VECO implemented its proposed change in accounting method and prepared its FYE 2005 Form 1120 accordingly. As a result of the change in accounting method, VECO claimed deductions for prepaid expenses and accrued expenses attributable to periods after March 31, 2005, under the theory that its tax treatment of the expenses was permitted under the all-events test of Code Sec. 461 and/or the recurring item exception under Code Sec. 461(h)(3).

An example of one such expense was an agreement between VECO and a technology company in which the technology company licensed use of its software and agreed to provide software maintenance services to VECO over a six consecutive year period from April 30, 2003, through March 30, 2008. VECO treated $200,235, which was attributable to the period April 1 to August 1, 2005, as an FYE 2006 expense on its financial statements but deducted that amount on it FYE 2005 tax return. Expenses relating to other agreements were treated in a similar manner.

In a notice of deficiency, the IRS disallowed the portions of the deductions attributable to periods after March 31, 2005, and accordingly determined a $1.9 million tax deficiency for VECO's FYE 2005 tax year. The IRS determined that VECO was not permitted to change its method of accounting for its prepaid and accrued expenditures. According to the IRS, VECO failed to establish that it incurred the expenses attributable to the disputed deductions in FYE 2005.

All-Events Test and Recurring Item Exception

Whether an accrual method taxpayer has incurred a deductible expense is determined under the all-events test of Code Sec. 461. Under this test, the amount of any deduction or credit allowed for income tax purposes is taken for the tax year that is the proper tax year under the method of accounting used in computing taxable income. Under the accrual method of accounting, a liability is incurred, and generally deducted for federal income tax purposes, in the tax year in which:

(1) all the events have occurred that establish the fact of the liability;

(2) the amount of the liability can be determined with reasonable accuracy; and

(3) economic performance has occurred with respect to the liability.

Conditions (1) and (2) are known as the traditional "all-events test," and existed before the addition of condition (3). To satisfy the traditional all-events test (i.e., conditions (1) and (2)), the liability must be final and definite in amount, must be fixed and absolute, and must be unconditional. The fact-of-liability prong of the all-events test looks to whether legal rights or obligations exist as of the close of the tax year, not the probability that such rights or obligations will arise at some point in the future. A liability is considered fixed when payment is unconditionally due or when the required performance occurs on the part of the other party.

If the liability is attributable to the provision of services or property to the taxpayer by another person, economic performance occurs as the person provides such services or property. If the liability is attributable to the use of property by the taxpayer, economic performance occurs as the taxpayer uses such property.

However, a taxpayer can treat services or property as being provided to the taxpayer as the taxpayer makes payment to the person providing the services or property if the taxpayer can reasonably expect the person to provide the services or property within 3-1/2 months after the date of payment. Code Sec. 461(h)(3) provides an exception (the recurring item exception) to the general rule requiring economic performance. Under the recurring item exception, a taxpayer may treat an item as incurred during any tax year if (1) the all-events test with respect to such item is met during the tax year, and (2) economic performance with respect to such item occurs within the shorter of a reasonable period after the close of the tax year or 8-1/2 months after the close of the tax year; (3) such item is recurring in nature and the taxpayer consistently treats items of such kind as incurred in the tax year in which the requirements of (1), above, are met; and (4) either the item is not a material item, or the accrual of such item in the tax year in which the requirements of (1), above, are met results in a more proper match against income than accruing such item in the tax year in which economic performance occurs.

Code Sec. 461(h)(3)(B) and Reg. Sec. 1.461-5(b)(4) address the materiality requirement and provide that (1) in determining whether a liability is material, consideration is given to the amount of the liability in absolute terms and in relation to the amount of other items of income and expense attributable to the same activity; and (2) a liability is material if it is material for financial statement purposes under generally accepted accounting principles (GAAP); (3) the treatment of an item for financial statement purposes is taken into account in determining if an item is material; and (4) a liability that is immaterial for financial statement purposes is not necessarily immaterial for tax purposes.

VECO argued that upon its entering into the various agreements, its liabilities under those agreements became fixed by virtue of its assumption of the contractual obligations. The IRS disagreed that VEOC's execution of each agreement constituted an event that fixed VECO's liability for the entire obligation under the agreement.

According to the IRS, VECO failed to satisfy the economic performance requirement and the materiality or matching requirement of the recurring item exception for all of the disputed deductions. VECO disagreed, contending that economic performance with respect to each expense item occurred within 8-1/2 months after the close of its FYE 2005 and that each expense item was not material.

Tax Court's Decision

The Tax Court held that because neither the required performances nor the payment due dates with respect to the majority of the accelerated deductions occurred before the close of VECO's 2005 tax year, VECO failed to satisfy the first requirement of the all-events test. In other words, VECO failed to prove that all of the events had occurred to establish the fact of the liabilities. According to the court, the execution of a contract contemplating payment, without more, is not an event that fixes the payor's liability.

In addition, the court held that VECO did not satisfy all of the requirements for the recurring item exception because the liabilities underlying the deductions were prorated over more than one tax year, were treated inconsistently for financial statement and tax purposes, and were material items for tax purposes.

With respect to the materiality requirement, the court noted that VECO prepared its financial statements in accordance with GAAP and accrued its liabilities under certain agreements and leases over more than one year for financial statement purposes. On its FYE 2006 financial statement, the court observed, VECO treated the disputed deductions as expenses for that year but deducted the expenses on its tax return for the prior tax year. Guided by Code Sec. 461(h)(3)(B) and an example in the legislative history, the court concluded that the liabilities giving rise to the disputed deductions were material because VECO prorated the liabilities between two years on its financial statements and took an inconsistent position with respect to the liabilities for financial statement and tax reporting purposes.(Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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