Income Tax Index
text Chapter Eight
Tax Two Index
Accrual Method
! INCOME
All Events Test
P Doubtful Collectibility
P Unenforceability
Earlier of Test
P History of the test
! DEDUCTIONS
All Events Test
§ 461(h): Economic Performance
Test
Relationship between accrual of
deductions and the time value of
money
This is the difficult part.
The same issues arise with
regard to accrual of income
and the “earlier of” test;
however, they are better
illustrated with deductions
and the “economic
performance” test of § 461(h).
1
text
Accrual Method: Income
All Events Test
Include an amount when all events have occurred such that the
taxpayer has a right to the item and the amount thereof can be
determined with reasonable accuracy.
This is the same rule as for Generally Accepted Accounting
Principles [GAAP].
As seen in the next slides,
courts have added
“collectibility” as a factor of
all events inclusion.
A similar rule exists for
deductions; however, the Code
also includes the “economic
performance” test for deductions.
Although common sense might
suggest that “enforceability” is
a precursor to accrual, it is not
always so!
2
Spring City Foundry v. Comm’r, 292 U.S. 182, (1934)
! FACTS:
Accrual Taxpayer/seller in 1920
Sold goods on open account, March to September
Later in the year, the customer had financial trouble
P customer filed for bankruptcy in December
! ISSUE:
Were the accounts receivable to be accrued?
Was the debt deductible as worthless?
! HOLDING:
Yes as to income.
P At the time “all events” occurred, the doubt did not yet exist.
No as to the deduction.
P The code then allowed a deduction only for wholly worthless
debts.
Collectibility is an element of the “all events” test.
An item need not be included if it is not collectible.
3
Clifton Manufacturing Co. v. Comm’r, 137 F.2d 290 (4th Cir. 1943)
P FACTS:
Accrual taxpayer earned interest income in 1933 and 1934.
At the time “all events” occurred, severe doubt existed as to
collectibility.
By 1934, some hope of collection developed.
By 1936, collection became certain.
Taxpayer collected in 1937.
Taxpayer never reported the income. All years prior to 1937 were
closed.
P ISSUE:
When was the interest includible?
P HOLDING:
1936 - when collection became “assured.”
“The debt should be accrued and reported as income when its collectibility is assured.
This procedure is in harmony with the principle of accrual accounting which regards
the right to receive, accompanied by collectibility, as the criterion; and it accords with
the decisions which hold that as soon as the right to receive is fixed, as in cases where
the taxpayer's claim is in litigation, the taxpayer must accrue and report the debt as
income even though it is not paid until a later date.”
4
Jones Lumber Company v. Comm’r, 404 F.2d 764 (6th Cir. 1968)
! FACTS:
Home builder sold houses for two promissory notes.
P One note secured by a first mortgage.
P Second note secured by a second mortgage.
TP typically sold the first notes and included the
amount received.
TP deferred accrual of the second notes until
collection.
P It argued the notes were subordinate, conditioned on the
first notes being paid, and the financial condition of the
makers was questionable.
This treatment was not
correct - but it went
unchallenged.
Probably, the error was
inconsequential. TP
should have included
the face amount and
then deducted a loss
on the factoring.
! HOLDING:
TP had to include the face amount of the second
notes.
Insolvency is necessary for a finding that a note is so
uncollectible as to prevent accrual.
Market
value of the notes is irrelevant for an accrual
taxpayer, which must include the face amount.
See also, Rev.
Rul. 80-361, 19802 C.B. 164.
“To prevent accrual because of doubtful collectibility
there must be a definite showing that the insolvency
of the debtor makes receipt improbable.”
5
text
Enforceability
P Obligations of the United States are unenforceable without an
appropriation by Congress.
Nevertheless, accrual of amounts due from the U.S. is appropriate.
– Rev. Rul. 70-151
P Gambling debts are generally unenforceable
An accrual taxpayer must nevertheless include winnings, even if the debt is
unenforceable.
– Desert Palace Inc. v. Comm’r, 698 F. 2d 1229 (9th Cir. 1982)
– Flamingo Resort Inc. v. U.S., 664 F.2d 1387 (9th cir. 1982)
But, the losing gambler has no discharge of indebtedness income if the
unenforceable debt is discharged.
– Zarin v. Comm’r, 916 F.2d 110 (3d Cir. 1990)
An estate is not entitled to a debt deduction for an unenforceable gambling
debt.
– Estate of Chagra, 60 T.C.M. 104 (1990) (CCH)
P Debts for future services are often unenforceable under state law.
An accrual taxpayer must nevertheless include the amount of any notes for
future services.
– Schlude v. Comm’r, 372 U.S. 128 (1963)
– Travis v. Comm’r, 406 F.2d 987 (6th Cir. 1969)
6
text
“Earlier of” Test
All Events Test
Include an amount when all events have occurred such
that the TP has a right to the item and the amount thereof
can be determined with reasonable accuracy.
Courts have modified the “all events test” to be:
Include at the earlier of the date the item is: The “earlier of”
test retains the
“all events” test
1. Due
as one of three
2. Paid
tests.
3. Earned
7
Factor 1 of “earlier of” test: Due
Include an item when it is “due” even if unpaid and unearned!
GAAP would either record nothing or would debit accounts receivable
and credit a liability.
For tax accounting, however, debit accounts receivable and credit
income.
Client can avoid this by contractually providing a later due date; however,
the client may not want to (they may need the money).
Factor 2 of “earlier of” test: Paid
Include when “paid” even if unearned!
! Imposes cash method on accrual TPs.
Factor 3 of the “earlier of” test: ! Subject to “payment” versus “deposit” issues.
Earned
! “Constructive receipt” is a payment.
This is just the traditional “all
events” test.
! “Cash equivalent” is a payment.
! “Economic benefit” is a payment.
8
History of Earlier of Test
1954 Code
! § 452 allowed deferral of pre-paid amounts up to six years.
! § 462 allowed reserves for estimated expenses to match with
income recognized early .
Sections 452 and 462 were repealed in 1955.
The idea was good and fair because it promoted matching.
But, it lost lots of revenue in the short run:
Many TPs deferred income and thus paid less tax.
Other TPs accrued expenses early and paid less tax.
Eventually, it would balance out because deferred income
would get taxed and accrued deductions would not be
deducted again in the future. But, in the short run, the
treasury could not afford it.
9
Beacon Publishing Co. v. Comm’r , 218 F.2d 697 (10 Cir. 1955)
! FACTS:
TP received prepaid amounts for newspaper subscriptions.
! HOLDING:
Court permitted deferral until the amounts were earned!
[later § 455 was added to do this]
Schuessler v. Comm’r, 230 F.2d 722 (5th Cir. 1956)
FACTS:
TP received advance payment for obligation to turn gas
on and off over five years.
HOLDING:
Court required accrual of income.
But, permitted early accrual of expenses not yet incurred!
This satisfies matching; however, it permits deductions
prior to “all events.”
10
This is highly
unusual - it
would not be
permitted
today. See
§461(h).
Automobile Club of Michigan v. Comm’r, 353 U.S. 180 (1957)
! FACTS:
TP received pre-paid dues for
services.
Ratably did not clearly reflect
income.
Beacon & Schuessler involved
definite dates for “earning”
In this case, services were on
demand.
Club deferred ratably: month by
month.
! HOLDING:
Court required inclusion of the
entire amount on receipt.
They might never be demanded - or,
they might be intermittent. Hence,
ratable inclusion did not clearly reflect
income. Thus, the TP may as well
include it all on receipt.
Congress enacted § 455 in 1958
To alleviate the harshness of the Auto Club decision, Congress enacted
section 455 to permit deferral of pre-paid subscription income.
11
Bressner, 267 F.2d 520 (2d Cir. 1959)
! FACTS:
TP sold TVs and service contracts.
Received pre-paid amounts for future service.
Used statistics to show when “earned” and thus distinguished
Auto Club (which sought to use ratable deferral).
! HOLDING:
Permitted deferral of pre-paid amounts.
While this case is historically
interesting, it was overruled by the 2d
Circuit in the RCA decision in 1980. It is
useful to illustrate the intensity of the
debate – and the general desire of the
courts to achieve matching.
12
American Automobile Association v. U.S., 367 U.S. 687 (1961)
Same facts as Auto Club of Michigan case.
This taxpayer had statistics to show that deferral with “ratable”
accrual accurately reflected true earning times.
Court required accrual on receipt.!
Statistics were not good enough.
Auto Club of New York, 304 F.2d 781 (2d Cir. 1962)
Followed the S.C. in Auto Club of Michigan and AAA cases.
But, asserted that Bressner was still good law because it involved very
good statistics.
While this case is historically interesting, it was effectively
overruled by the 2d Circuit in the RCA decision in 1980. It is
useful to illustrate the intensity of the debate - and the general
desire of the courts to achieve matching. The court was
willing to distinguish two Supreme Court decisions.
13
Schlude v. Comm’r, 372 U.S. 128 (1963)
! FACTS:
Arthur Murray Dance Studio
Received, in advance, for dance lessons:
P cash
P negotiable notes
P contract rights (non-negotiable and unenforceable)
TP wanted to defer income until earned: when lessons
were provided.
! HOLDING:
Court required inclusion of all three types of “payment”!
(4 dissents)
Cash:
Because the services were “on demand” and the TP
could show no “pinpoint accuracy” as to when earned.
Relied on repeal of §§ 452 and 462.
14
Schlude [continued]
Negotiable notes:
Essentially the Court put these accrual TPs on the cash method by
including the notes.
The Court required inclusion of the fair market value of the notes.
The Court did not discuss traditional “cash equivalent” factors; hence,
this may be a harsher rule than cash method TPS face!
Contract Rights:
The Court required inclusion of the contract rights
even though the amounts were:
unearned
unpaid
unenforceable
non-negotiable
unfunded
And then the
Tax Court made
it even worse!
See the next slide
This is a very harsh rule.
15
Schlude v. Comm’r, 22 T.C.M. 1617 (1963) (CCH)
The Supreme Court remanded the Schlude case for further determination of
the amount of income. In footnote 10 of its opinion, the Court explained:
Negotiable notes are regarded as the equivalent of cash receipts, to the extent
of their fair market value, for the purposes of recognition of income. § 39.22(a)-4, Treas. Reg. 118, 1939 Code; § 1.61--2(d)(4), Treas. Reg., 1954 Code; Mertens,
Federal Income Taxation (1961), § 11.07. See Pinellas Ice & Cold Storage Co. v.
Commissioner, 287 U.S. 462, 53 S.Ct. 257, 77 L.Ed. 428.
On remand, the taxpayer sought to include the fair market value of the notes;
however, the Tax Court - in a memorandum opinion - found for the
government, disagreeing with the Supreme Court’s plain language:
Petitioners, in their brief, seem to be taking a footnote of the opinion out of
context and building their case on that footnote. If we accepted petitioners'
interpretation of the Supreme Court's footnote 10 to its opinion, we would
have to say that an accrual basis taxpayer accrues negotiable notes at fair
market value and not face value. This is not the law on this point . . .
The better view, however, is that the Supreme Court was correct: if an
accrual taxpayer is placed on the cash method with regard to the receipt of
notes, then it should be on the full cash method for that item: thus it
should include notes at fair market value. The Tax Court is correct
regarding the law for accrual taxpayers; however, for this item, Schlude
was no longer an accrual taxpayer.
16
Artnell Co. v. Comm’r, 400 F.2d 981 (7th Cir. 1968)
! FACTS:
Chicago White Sox sold tickets in advance.
TP proved pinpoint accuracy of when it is earned.
P Typically the games were played the following year - in a matter
of months.
! HOLDING:
The court permitted deferral until the games were played.
The court called the “earlier of” rule abusive in this case.
While this case is very interesting, it is an isolated example of
a Circuit Court being willing to distinguish the trilogy. It is
not a case to use for planning, unless the facts are very
similar - and not without very clear disclosure to the client. It
does, however, make a good case to rely on for litigation.
17
Hagan Advertising Displays, Inc. v. Comm’r, 407 F.2d 1105 (Ct. Cl. 1969)
! FACTS:
TP received advance payments for signs it manufactured.
TP sought deferral until delivery of the signs.
Deferral would match with recognition of the expense through cost
of goods sold.
! HOLDING:
Cost of goods sold is not a deduction; instead, it is a
reduction from gross receipts to determine gross income.
The court denied deferral, relying on the trilogy.
But, the court hinted strongly that it would approve a “deduction” for
estimated cost of goods sold!
P But, because TP did not request the deduction, the court did not
allow it.
P Nevertheless, the court struggled for a way to achieve matching.
The early recognition of cost of goods sold would be
unusual, but not unprecedented. It is now sometimes
permitted by Treas. Reg. § 1.451-5.
18
Rev. Proc. 71-21, 1971-2 C.B. 549
Treasury issued this Revenue Procedure to partially
alleviate the harshness of the trilogy.
If - and only if - all of the services are to be performed
within the next year, a taxpayer may defer recognition of
an advance payment until the following year.
This undoes Schlude to a limited extent.
Note:
It only applies to prepayments for services.
It specifically applies to dance studios.
19
Treas. Reg. § 1.451-5
Advance payments for the sale of goods.
Permits limited deferral of advance payments until the year they become
“substantial.”
Permits limited early accrual of Cost of Goods Sold.
Per § 1.451-5(b)(1), advance payments for goods must be included in income
either (i) in the year of receipt, or (ii) in the year in which properly accruable for
purposes of financial accounting,
but, no later than the end of the second year following the year in which the TP
(i) receives “substantial payments” and (ii) has on hand (or available) goods of
substantially similar kind and in sufficient quantify to satisfy the agreement.
Substantial payments exist if the cumulative advance
payments pursuant to an agreement “equal or exceed
the total costs and expenditures reasonably estimated
as includible in inventory with respect to such
agreement.”
Gift certificates are always “substantial payments.”
20
If the TP must include
advance payments
because they are
substantial, then he
must also take into
account the related
cost of goods sold.
Automated Marketing System, Inc. v. U.S., 34 AFTR 2d 74-542 (Dist. Ill, 5/13/74)
In this relatively unimportant case, the District Court allowed
deferral for pre-paid amounts. The decision was appealable to
the 7th Circuit, which is the Artnell court.
P TP acquired a corporation midway through its taxable year.
The acquired corporation was in the business of selling sales follow-up
programs to automobile dealers.
Payment was made in advance for services to be rendered by the
acquired corporation over a period of between twelve and thirty months.
P At the time of acquisition, the acquired corporation had a large
amount of prepaid income.
In an unpublished order, the Seventh Circuit affirmed the District Court
decision which held that the deferral of prepaid income in that case
clearly reflected income
While the case is not one to rely on for planning, it is something to add
to a litigation position: so few cases permit deferral of prepaid amounts,
a litigant ought not ignore any - even one from a District Court.
21
Boise Cascade Corp. v. U.S., 530 F.2d 1367 (Ct. Cl. 1976)
! FACTS:
TP received substantial advance payments for engineering
services.
P Some were set for specific times.
P Some were on demand.
! HOLDING:
The court permitted deferral until performance.
! WHY:
Better matching with expenses.
P Services not solely “on demand.”
P Large sums of money were involved – customers would surely
eventually demand them.
This is unlike the trilogy, in which the services might never have
been demanded.
Note: this is a Claims Court case.
22
Morgan Guaranty Trust Co. v. U.S., 585 F.2d. 988 (Ct. Cl 1978)
! FACTS:
TP received interest “pre-paid” and sought deferral.
The amounts were very small, compared to the size of the Bank.
The time periods were quite short - less than one year.
! HOLDING:
The court permitted deferral.
Why?
P Short term (till following year)
P De minimis amounts
P Pinpoint accuracy
Note: §§ 1272-3 require this result since 1982.
Again, this is the Claims Court willing to distinguish the trilogy.
23
Collegiate Cap & Gown Co. v. Comm’r, 37 T.C.M. 960 (1978) (CCH) (appealable to 7th Cir.)
! FACTS:
TP received advance payments for regalia rental.
Time periods were short - generally about six months.
Rental dates were fixed.
! HOLDING:
The court permitted deferral.
Why:
P Pinpoint accuracy
P Short term.
Note that while this is a Tax Court decision, citation to it is problematic:
– It is a TCM.
– It is appealable to the 7th Circuit (the Artnell Circuit) and
explainable by the Golsen rule.
Golsen v. Commissioner, 54 T.C. 742 (1970), aff’d. 445 F.2d 985 (10th
Cir. 1971), cert. denied 404 U.S. 940 (1971) [The Tax Court is bound by
authorities of the Circuit to which the case is appealable].
24
RCA Corp. v. U.S., 664 F.2d 886 (2d Cir., 1981)
! FACTS:
TP sole TVs and multi-year service contracts.
TP received advance payments for service contracts.
The District Court permitted deferral.
P It relied on Bressner.
TP had extremely good statistics regarding when the services
would be earned.
P While some customers would not need any services and some
would require much, statistics could very accurately show - in a
macro sense - when and of what type would be demanded.
! HOLDING:
2d Circuit reversed and required inclusion, relying on trilogy.
The court overruled its prior decision in Bressner.
25
Summary of Earlier of Test
With 5 limited court exceptions, and a few code and administrative
exceptions, an accrual TP must include income on the earlier of
receipt, the due date for receipt, or earning.
Majority view: — Automobile Club of Michigan (SC)
— AAA (SC)
— Schlude (SC)
These
— RCA (2d Cir)
Greatly
Exceptions: — Morgan Guaranty (CC)
outweigh
— Artnell(7th Cir)
— Boise Cascade
— Collegiate Cap & Gown (TCM)
These
— Automated Marketing Systems (D. ILL)
— Some services per Rev. Proc. 71-21
— Some goods per Treas. Reg. §1.451-5
— interest per §§ 1272-86
26
slides on TVM and income
text
Regulation Definition:
1.446-1(c)(1)(ii)
Accrual of Deductions
Overview and comparison with income accrual
The premise behind deferred comp
plans is that deferral of receiving the
money - coupled with tax deferral - is
superior economically to receiving the
money currently with current tax.
Hence the Schlude rule is best avoided if
possible - even with a change of facts –
don’t accept advance payments.
Due
Income
Paid
“Earlier of “Test
Earned
(All Events)
Accrual Method
All Events
The economic disadvantage from
deferring deductions prompts
similar analysis: you are better off
paying now and deducting now
than pay later and deduct later.
Deductions
“Later of” Test
Economic
Performance
27
Matching Principle
Touchstone for Accounting and GAAP
FACTS:
7
7
7
7
John mows Jane’s lawn in 1999.
Jane paid John $100 in 1998.
John buys $10 of fuel in 1999.
John changes $5 mower filter in 2000
(as a result of 1999 use).
Even in this simple
example, this part of the
analysis is debatable.
1998
1999
2000
$100
$100
(10)
(5)
$ 85
(5)
Proper
Matching
28
Allin1999whenearned
andincurred
Consequences of Matching
Clear Reflection of Income
P John had no true accession to wealth in 1998 because he had not yet
earned the $100 and might have to refund it.
But, he received the money and formed the contract. This gave him at least
some of the elements of increased wealth, although not in the traditional
accounting sense.
P Also, in 2000 he suffered no loss [the $5] because that cost was really
incurred or suffered in 1999 when the repair became necessary.
A substantial question exists as to whether John should deduct, in 1999,
the predicted cost of $5 to replace the filter, or whether he should, in 2000,
deduct the cost of the last filter installed.
More on this issue, later.
P In 1999, he really profited $85 from the mowing — he earned $100 and
incurred related costs of $15.
Reporting $90 profit or a $10 loss in 1999 might lead to management
mistakes: the year was profitable, but not to that degree. Likewise, reporting
a profit of $100 in 1998 could lead to huge mistakes: he made a profit
without providing any services. Hence, perhaps he could do without any
workers? Of course not, but you only know that because of information
provided by the matching principle.
P Hence GAAP and the matching principle provide him with usable and
reasonably accurate information regarding each year.
This differs significantly from what the cash method would determine to be
income for each year.
29
Tax Accounting
Aims more to raise revenue rather than to match income and
expenses
Hence, income is recognized earlier and deductions later than
per GAAP.
1998
1999
2000
$100
$100
$(10)
$(5)
(5)
Schlude
“Earlier of”
Test
Include when
paid
GAAP
“All Events”
Test
461(h)
“Economic
Performance”
Test
Deduct when
incurred
Delay until
performance
30
Tax Accounting
Caution to Accountants and General Practitioners
P As the prior slides show, tax accounting differs from financial
accounting.
Income is sometimes recognized earlier than GAAP provides
per the Schlude “earlier of” test.
– but, remember the many exceptions, e.g., Rev. Proc. 71-21; Treas.
Reg. § 1.451-5; I.R.C. §§ 455, 456, 1272-86, Artnell, Boise Cascade,
Collegiate Cap & Gown
expenses are sometimes deducted later than GAAP provides
per the §461(h) economic performance test
The point is to raise revenue, rather than to “clearly reflect
income” (although courts and the government insist that is
still the goal).
Remember, most – if not all – accrual taxpayers will have multiple sets of
books and financial statements: one for tax, one for GAAP, and others
for particular contractual or regulatory audiences. Be careful which you
rely on for family law and other such legal purposes: tax books are not
primarily intended to “clearly reflect income” and thus may not.
31
text
Historic Cases
Prior to the enactment of the economic performance test, several cases were important in
the accrual of deductions. While mostly of historic importance now, these cases are worth
reviewing as illustrations of the climate in which Congress enacted § 461(h). In some
cases, the result was different than that later enacted; in others, the result was the same.
P Mooney Aircraft, Inc. v. U.S., 420 F.2d 400 (5th Cir. 1969)
A manufacturer/seller may not currently deduct the cost of future rebates due when
the planes are retired from service. The due dates are too imprecise and too far into
the future.
P Lawyers’ Title Guarantee Fund v. U.S., 508 F.2d 1 (5th Cir. 1975)
A title insurance fund may currently deduct the future cost of payments to attorneys
for work performed currently and to be paid in seven years. See also, Washington
Post Co. v. U.S., 405 F.2d 1279 (Cl. Ct. 1969).
P World Airways, Inc. v. Comm’r, 62 T.C. 786 (1974), aff’d 564 F.2d 886 (9th Cir.
1977)
An airline may not currently deduct the estimated future cost of repairs necessitated
by current flights.
P U. S. v. Hughes Properties, Inc., 476 U.S. 593 (1986)
A casino may currently deduct the future cost of paying a progressive slot jackpot.
P Ford Motor Co. v. Comm’r, 71 F.3d 209 (6th Cir. 1995) [involving years prior
to the enactment of § 461(h)]
Contrary to custom, a tortfeasor may only deduct the present value of future
payments.
32
Historic Cases
The cases on the prior slide each involve the same essential facts: an item for
which “all events” – according to GAAP – has occurred, but for which the
government sought to disallow a deduction.
Sometimes, the government won these cases – and sometimes it lost.
Distinctions existed and the different holdings were arguably defensible;
however, a better argument was that the distinctions were ultimately
meaningless and thus the cases resulted in unfair treatment for some taxpayers.
Much more consistency exists today under § 461(h) . . .
. . . but it is paid for at the cost of “unfairness” to many more
taxpayers . . .
. . .arguably resulting in significant economic
distortions.
33
I.R.C. § 461(h)
Economic Performance Requirement for Accrual of Deductions
P For accrual method Taxpayers to deduct an amount, both
the “all events” and “economic performance” tests must
be satisfied.
P This section does not apply to cash method taxpayers.
P Treasury Regulations interpret the statute aggressively,
so read the examples carefully.
34
Section 461(h)(2)
Time when economic performance occurs
The Code provides 4 categories of economic performance
rules:
P (A) Services and Property provided to the TP
P (B) Services and property provided by the TP
P (C) Workers Compensation and Tort liabilities of the TP
P (D) Other Items — In the case of any other liability of the
TP, economic performance occurs at the time determined
under regulations prescribed by the Secretary.
35
Examples of the categories
The four categories are really seven - if we include Beware: the categories
the three subparts of (A) plus the recurring items overlap - or at least appear
to do so. Hence, keeping
exception.
them separate is not easy.
As you read each category, you should contemplate
an example that illustrates the provision. Ideally,
the example should be one which delays a
deduction beyond the occurrence of “all events.”
If the example provides for “economic
performance” prior to “all events,” a deduction
will not be appropriate until “all events”
occurs; hence, the example will not illustrate
the code section having any consequence.
This is not always
possible; hence, you
may be frustrated by
the code section.
Also, if the example provides for “economic
performance” occurring in the same year as
“all events,” the example will not illustrate the
code section having any consequence.
36
1. Examples of § 461(h)(2)(A)(i)
(A) If the liability of the TP arises out of
Note the “arises out of” language.
(i) the providing of services to the TP by another
person, economic performance occurs as such person
provides such services
In year two, taxpayer holds the
concert. Patrons create quite a
mess, which the taxpayer must pay
someone to clean up in Year Three.
When may he deduct the cost of
clean-up?
In year one , taxpayer plans a
concert to be held in year two. In
preparation, it arranges for design
and logistical services, which are
performed in year one. When may
he deduct the planning costs?
Under the cash method, TP may deduct the planning costs when paid in
year one, subject to the capitalization rules of Treas. Reg. § 1.461-1,
Zaninovich , and Grynberg. He may deduct cleanup in year three, when
paid.
Under the accrual method, TP may not deduct the planning costs until
year two, when both all events and economic performance are met. he
may not deduct the cleanup costs until year three when economic
performance occurs, even though all events occurred in year two.
37
Summary
P 461(h)(2)(A)(i) sometimes makes a difference. If all events have
occurred necessitating a service to be provided by another, economic
performance will not occur until the services are provided.
In year one , taxpayer plans a
concert to be held in year two. In
preparation, it arranges for design
and logistical services, which are
performed in year one. When may
he deduct the planning costs?
461(h) has no effect: EP is
probably met in year one
and AE in year two.
In year two, taxpayer holds the
concert. Patrons create quite a
mess, which the taxpayer must
pay someone to clean up in
Year Three. When may he
deduct the cost of clean-up?
461(h) has an effect: EP
occurs in year three, but
AE occurred in year two.
But, even this did not change the “law” as the
World Airways case required the same result
prior to 461(h)’s enactment.
38
2. Example of § 461(h)(2)(A)(ii)
(A) If the liability of the TP arises out of
(ii) the providing of property to the TP by another person, economic
performance occurs as such person provides such property
Example:
The concert promoter purchases
and consumes substantial supplies
in year two in connection with the
concert. When may he deduct the
cost of supplies?
Or, he bought the supplies in year
one and used them in year two.
Under the cash method, TP could deduct the supplies in year
one, subject to the capitalization rules.
Pursuant to the accrual method, “all events” would not occur
until the supplies were used in year two. “Economic
performance” in an earlier year would thus be irrelevant.
How does this reconcile with section
179? Does it apply to accrual taxpayers,
or does section 461(h) override it
whenever it involves property provided
by another?
39
2. Example of § 461(h)(2)(A)(ii) [continued]
Caution: The prior slide is a poor example (but the best I
have, for now) for two reasons:
! the regs provide no guidance or example
explaining clause (ii)
! Promoter’s deduction for supplies expense has
nothing to do with his acquisition of the supplies; rather it
has to do with his use and consumption of them; hence
the “arising out of” language can seem confusing.
In a later slide, I’ll
provide an
example which, I
believe, illustrates
the provision: one
in which “all
events” occurs
prior to the
acquisition of the
property.
Query: what is the
purpose for this clause?
Can you think of a good
example - in which the
rule has consequences?
You need to think of an example in
which “economic performance” follows
- rather than precedes or coincides with
- “all events.” Only in such a case does
the provision matter.
40
3. Example of § 461(h)(2)(A)(iii)
(A) If the liability of the TP arises out of
(iii) the use of property by the taxpayer, economic performance occurs as
the taxpayer uses such property
The concert promoter in
rents the stadium in which he
holds the concert. When may he
deduct the rental expense?
Under the cash method, TPcould deduct the lease payments as
he made the payments, subject to the capitalization rules of
Zaninovich and Grynberg, as well as § 467.
Under the accrual method,TP could not deduct the lease
payments until year two - the year he uses the property.
Query: what is the
purpose of this clause?
Can you think of an example to which it applies
and to which economic performance occurs in a
year later than “all events.” Without such an
example, the provision is meaningless, is it not?
41
3. Example of § 461(h)(2)(A)(iii) [continued]
The example on the prior slide is consistent with reg examples 6 - 9 of
Treas. Reg. § 1.461-4(d)(7). Example 6 deals with rental of a plane, 7
deals with an exclusive use contract, 8 with rental of a copy machine, and
9 with the use of some other product.
Each has both a fixed and variable rent component. Economic
performance occurs with regard to both types of rent as the TP uses the
rented property (as opposed to pays for it).
SO WHAT! “All events” and “economic performance” occur as the
TP uses the property in nearly all cases. These examples- and all
that I think of - add very little, if anything.
The next slide looks at some details of these examples.
Also, several later slides refer to them. Facially, the examples seem
fine; however, on close examination, do they add anything?
42
3. Example of § 461(h)(2)(A)(iii) [continued]
The prior clause – § 461(h)(2)(A)(iii) – would make sense if it applied to
liabilities other than the payment of rent “arising out of” a Taxpayer’s
use of his own or leased property
Examples: As an airline uses a plane, it incurs liabilities under FAA
rules to overhaul the plane. Arguably, for each mile
flown it should accrue some portion of the future
maintenance costs – which arise from its use of the
plane. GAAP would require this.
The regulation
interpretation
may be fairly
criticized;
however, it is
quite clear.
Or, as an oil company uses leases property for
drilling, it incurs contractual liability to repair damage
and to dismantle the rig. This substantial liability
arguably “arises from” its use of the oil lease. GAAP
would require accrual.
Treas. Reg. Ex. 6 deals with airline recommissioning costs on rented
planes and Ex. 1 with oil rig dismantling costs on leased property. In
each case, the reg views the costs [as opposed to the fixed rent] as
either § 461(h)(2)(A)(i) [services provided to the TP] or (h)(2)(B)
[services provided by the TP] and thus defers the deduction until the
services are provided.
The taxpayer
must use
supplies or
other property
to provide the
repair or
dismantling
services.
Would
economic
performance
occur as the
Taxpayer
purchased the
supplies or as
it used them or
when it used
the plane or
rig?
43
3. Example of § 461(h)(2)(A)(iii) [continued]
! 461(h)(2)(A) has an “arises out of” relationship test
! 461(h)(2)(B) has no such test – it applies if a liability requires a
taxpayer to do something
! But, a liability to do something may itself arise out of a taxpayer’s
use of property.
For example, the airline repair costs arise out of the use of the plane.
But, they also constitute a liability requiring the taxpayer to do
something – the repair.
Thus, both provisions appear to apply, although they define economic
performance differently.
P (A)(iii) defines economic performance as the use of the property –
when the plane is flown.
P (B) defines economic performance as the provision of the repair –
which may be years after the related flights.
44
3. Example of § 461(h)(2)(A)(iii) [continued]
The Treasury Regulations choose (B) as the model for such repair
costs which arise from the use of property.
Logically, all that is left of (A)(iii) is rent expense arising from the use of
property provided by another. In fact, all regulation examples illustrating
(A)(iii) involve such facts. Also, the regulation itself uses the phrase “the use
of property provided to the taxpayer,” suggesting that (A)(iii) does not apply to
costs arising from the use of the taxpayer’s own property.
This further leads to the conclusion that (A)(iii) only applies to rent.
But, this conclusion is odd because in such cases “all events” and
“economic performance” would seem to be simultaneous. As a result,
the provision appears to serve no purpose.
Note: at this point, I have concluded that (A)(i)
sometimes has a real effect, (A)(ii) has no apparent
effect, and (A)(iii) has no apparent effect.
45
4. Example of § 461(h)(2)(C)
Tort Liability and Worker’s Compensation Costs — defer until payment
(C) — If the liability of the taxpayer requires a payment to another person and
(i) arises under any workers compensation act, or
(ii) arises out of any tort,
economic performance occurs as the payments to such person are made.
Subparagraphs (A) and (B) shall not apply to any liability described in the
preceding sentence.
Without the last sentence, such costs would appear to arise from (A)(i) [employees
providing services] or (B) [taxpayer providing property or services]. If that were
the case, a deduction might be appropriate as the services were provided.
However, the code clearly defers such deductions until payment.
Economic Performance occurs
as payments are made.
All Events occurs when
the tort or injury occurs.
Under the cash method, the tortfeasor could deduct as payments are made.
Under the accrual method, the answer is the same: deduct as payments are made.
This rule diverges significantly from GAAP, which
would likely require deducting in the year of the tort.
46
Willis Article Three
4. Tort Liabilities - old custom [continued]
Pre-1986 customary treatment unfairly favored tortfeasors.
P Hypo: airline crashes plane in 1982 and settles the tort case, agreeing to pay $4
million/year for 25 years. Total liability equals $100,000,000.
P Present value, discounted at 8%, equals $46,115,033.13.
Using begin mode, 8% nominal annual interest, and one payment per year.
P GAAP recognized an expense equal to present value— to match with the
revenue from the flight, as well as the year of low maintenance (though not
perfectly), plus the interest over time.
Hence taxpayer would deduct $46,115,033.13 currently for financial purposes and
$53,884,966.87 over time, as interest.
P Tax tradition permitted a deduction of $100,000,000 for tax purposes despite
the GAAP treatment.
P TP would save 46% [old corporate rate] or $46,000,000. Tax savings produced
sufficient interest income (measured by the airline’s cost of capital or return on
investment) to amortize the liability.
P TP could then keep the principal.
P Hence it was more profitable to crash planes than to fly them
47
4. Tort Liability - current law [continued]
The rule now favors the government.
P TP tortfeasor can only deduct payments, including
interest, as they are made.
This is inconsistent with GAAP - but now defers to a period
later than GAAP, while the old rule accrue prior to GAAP. It
is really just as unfair - only in the opposite direction.
P This causes two problems:
1. It mis-matches income and related costs.
2. It deprives TP of a significant part of the “value” of the
deduction.
P Nevertheless, this is clearly the rule adopted by
Congress in § 461(h)(2)(C).
Click Here to see my
If you are viewing this electronically,
click here for the proof. Otherwise,
see the outlines on my web site
48
Albertson’s discussion for
proof.
Willis ArticleThree
5. Example of § 461(h)(3) Recurring Items
The Economic Performance test is not applicable.
P (A) — Notwithstanding paragraph (1) an item shall be treated as
incurred during any taxable year if- (i) the all events test with respect to such item is met during such
taxable year . . .
(ii) economic performance . . . occurs within the shorter of
– (I) a reasonable period after . . . such . . . year, or
– (II) 8 ½ months after the close of such taxable year,
(iii) such item is recurring in nature and the taxpayer consistently
treats items as incurred in the . . . year in which . . . (i) are met, and
(iv) either —
– (I) such item is not a material item, or
– (II) the accrual of such item . . . results in a more proper match. . . than .
. . economic performance.
Query: when would it
not be a better match?
49
5. Example of a Recurring Item [continued]
Treas. Reg. § 1.461-5
P The regulation provides two examples – each dealing with
rebates on items sold. §1.461-5(e)
P If the rebates are recurring and within 8-1/2 months of the year
end, they are deductible in the year of sale if that provides a
better match regardless whether they are material.
Of course they will provide a better match – and GAAP would
require accrual in the year of sale. Without accrual, the
financial statements would be inaccurate.
What is this an exception to? The examples do not fit within
§§ 461(h)(2)(A), (B), or (C). Thus they are examples of (D) other items.
In general, the regulations provide that if none of
the categories fit, then economic performance
occurs with payment. The recurring item provision
is an exception to that rule. But, what is the point
of a statutory exception to a regulatory exception?
50
I thus conclude that
this portion of the
code section serves
no real purpose.
6. Example of § 461(h)(2)(B)
Note: this has no “arises
(B) — If the liability of the TP requires the TP to
provide property or services, economic performance out of” language.
occurs as the TP provides such property or services.
The concert promoter uses his
own employees and property to
provide the clean-up services rather than hiring independent
service providers. He does so in
year three. When may he deduct
the clean-up costs?
Under the cash method, TP could not deduct the cleanup until paid.
Pursuant to the accrual method, “all events” occurs in year two, but “economic
performance” occurs in year three, delaying the deduction until that year.
51
6. Example of § 461(h)(2)(B) [continued]
If a taxpayer purchases property which he uses in the providing of services or
property to another, an accrual deduction is appropriate as the services are
provided.
This is consistent with GAAP.
Whether we view this as an example of (A)(ii) or (A)(iii) or (B) does not matter.
The regulations apparently view it as an example of (B); however, that is not
entirely clear.
A restatement of the rule might be:
Economic performance with respect to costs directly associated with the
provision of services or property to another occurs as the services are
provided.
For this type of example, the provision is meaningless because it
results in the same answer as the traditional “all events” test.
52
6. Example of § 461(h)(2)(B) [continued]
Frequently, the use of property necessitates periodic repairs which occur in years
other than those involving use of the property. This presents an accounting problem.
For example, an airplane may require a major overhaul every three years. Hence a
plane first used in 1995 must be overhauled in 1998 and again in 2001 and again in
2004.
Do the 2001 repair costs apply to the period 2001 through 2004 [forward] or do they
apply to the period 1998 through 2001 [backward]? In other words, do we amortize
the costs [forward application] or do we anticipate them [backward]?
In the example, after 1998, it matters little because every year has costs matched to it.
The only significance would be the amount: in inflationary times, the amount
resulting from a forward rather than backward match might differ [unless we account
for that with the time value of money sections].
But, in the period 1995 through 1998, as well as in the last years of the airplane’s life,
the choice matters greatly. The backward (anticipatory or reserve)approach would
properly match, while the forward approach would produce no expense.
Hence, GAAP would usually require the backward approach – the anticipation of the
future costs to match with current revenues from current use. This not only matches
a cost to all years, but it also matches costs with the use that necessitated that
particular cost.
See the illustration on the next slide.
53
6. Example of § 461(h)(2)(B) [continued]
1995
1996
1997
1998 1999 2000
2001 2002 2003 2004
Repair
Repair
Repair
Repair
Repair
Repair
2005
Both Forward Amortization and Backward (reserve anticipation)result in a match
for most years – although the amounts may differ. The Backward approach is
preferable because it provides a match for the initial years.
As seen in later slides, the 461(h)(2)(B) approach provides for deduction in the
year of the repair, which will always be a mis-match for such non-annual repairs.
54
Oil Rig Dismantling Costs
Treas. Reg. § 1.461-4(d)(7) Ex. 1
P An oil company with an offshore lease must dismantle rigs at the
end of the lease, per the contract. The costs are very substantial.
P GAAP requires a deduction for a portion of the estimated future
costs during the years of production – this would match with the
proper income.
P This might appear to be covered by § 461(h)(2)(A)(ii) – the future
dismantling costs “arise out of” the taxpayer’s use of the lease.
P The regs classify it as § 461(h)(2)(B) — the liability requires the
taxpayer to provide services — thus economic performance
occurs as the taxpayer performs the dismantling.
This results in a mis-match of income and expenses; but,
it raises additional tax revenue, which was its purpose.
55
Airline Recommissioning Costs
Treas. Reg. § 1.461-4(d)(7) Ex. 6
P TP uses an airplane to fly passengers. For each hour/mile flown,
FAA rules require specified maintenance – some deferred until a
future year [e.g., every 1000 flights].
P GAAP would require recognition of an estimated expense for each
hour/mile flown — to match with passenger revenues.
P This might appear to be a § 461(h)(2)(A)(iii) situation, but it is not (in
the government’s view).
P Economic performance occurs as the repairs are made per
§461(h)(2)(A)(i) or (h)(2)(B).
This results in a mis-match of income and related
expenses; however, it does increase tax revenues.
56
Slot Machine Progression Costs
Treas. Reg. § 1.461-4(g)(8) Example 4
P A progressive slot machine promises a larger future jackpot for
each pull lost [e.g., you put in a dollar and lose, the pot increases
25 cents]. Large payoffs are often deferred for 1-3 years.
P GAAP requires the deduction of an expense for each jackpot
increase — to match with casino winnings.
P This might appear to be a § 461(h)(2)(B) situation – the jackpot
liability “arises out of” TP providing services; but the
government disagrees. Thus, economic performance occurs as
the jackpot is paid.
The reg results in a mis-match
This is a § 461(h)(2)(D) - other item.
of income and expenses.
Note: while § 461(h)(2)(A) begins with an “arising out of” trigger, § 461(h)(2)(B) has
no such language. This reading supports the regulation. However, a legitimate but shaky - argument stems from the “with respect to” language of § 461(h)(1): is
the jackpot liability “with respect to” the “item” of providing gambling services,
for which economic performance occurs in the year of gambling?
57
Summary
P
461(h)(2)(A)(i) sometimes makes a difference. If all events have occurred necessitating a
service to be provided by another, economic performance will not occur until the
services are provided.
P
461(h)(2)(A)(ii) initially appears to be meaningless. The regulations provide no clear
example.
P
461(h)(2)(A)(iii) appears to be meaningless. All regulation examples illustrating it involve
the payment of rent for the use of property owned by another. In no such example does
economic performance diverge from all events. Hence, the provision makes no
difference.
P
461(h)(2)(C) makes a difference – it reverses prior customs. Accrual of deductions arises
from a tort or worker’s compensation is appropriate as payments are made.
P
461(h)(3) sometimes makes a difference, although it is an exception to a regulation [an
odd role for a statute]. All regulation examples illustrating it involve the payments of
rebates. In such cases, an accrual deduction is appropriate in the year of sale -rather
than the year of payment - if the amounts are paid within 8-1/2 months of the year end.
This resolves some confusion under prior law.
P
461(h)(2)(B) is meaningless in many common examples. It also applies if TP uses his
own property in the provision of services which results in needed repairs: economic
performance then occurs as he repairs. This differs from GAAP and thus has significant
consequences.
P
461(h)(2)(D) has real consequences in that in cases such as the Progressive Slot Machine
example, economic performance - and thus accrual deduction -occurs later than GAAP
would provide.
58
Other Provisions for Deferred but Incurred Costs
Each of the following provisions deals with the
same theoretical situation – deferred incurred costs
– but achieves a different economic answer. Why?
P
P
P
P
P
P
P
P
Deferred Rental Agreements — § 467(a)
Solid Waste Reclamation Costs — § 468
Nuclear Power Decommissioning Costs — § 468A
Designated Settlement Funds — § 468B
Deferred Compensation in General — §§ 404 and 467(g)
Deferred Compensation of State/local and TEOs — § 457
Deferred interest expense — §§ 1272-86; 7872
Deferred Tax liability on installment obligations — § 453A(c)
[reverse theoretical situation]
59
Interest Costs
In general, economic performance for interest accrues overtime.
On first impression,
P Economically, interest accrues over time.
this might appear
hugely important.
P Per GAAP, interest accrues over time.
P Per § 1.461- 4(e), interest accrues [and economic performance occurs]
over time.
Whenever this applies, it will permit an interest
deduction prior to payment. This is consistent with the
various time value of money provisions, e.g. § 163(e).
But, be careful about what constitutes interest and when the regulation
applies.
P Per the regs, interest related to a tort settlement is not deductible until
paid.
P Per the Albertson’s, 42 F.3d 537 (9th Cir. 1994), case, interest on deferred
compensation is not really interest (and thus is deferred per § 404).
Query: will the regulation ever apply if “all
events” but not “economic performance” has
occurred as to the underlying liability?
60
I cannot think of an
example. Can you?
by
Steven J. Willis
(c) 1996
Albertson's v. Commissioner
http://nersp.nerdc.ufl.edu/~acadian/tax2/outline/outline.htm
Sources:
Daniel I. Halperin, "Ninth's Circuit's Decision in Albertson's is Outrageous," Tax Notes, February 21,
1994, p. 1083.
Steven J. Willis, "Leave Albertson's Alone," Tax Notes, June 13, 1994, p. 1481.
Daniel Halperin, "Albertson's: More 'Outrage,'" Tax Notes, June 27, 1994, p. 1771.
Steven J. Willis, "Albertson's: A Little Less Emotion, Please," Tax Notes, August 15, 1994, p. 961.
Jasper L. Cummings, Jr., "Statutory Interpretation and Albertson's," Tax Notes, January 23, 1995, p. 559.
Deborah A. Geier, "Interpreting Tax Legislation: The Role of Purpose," Tax Notes, May 8, 1995, p. 822.
I. Narrow View of the Case: Deferred Compensation Issues
A. Facts of the Case
Albertson's, Inc., an accrual method taxpayer, adopted a deferred compensation arrangement with 8 top
executives and 1 outside director, each of them cash method taxpayers. The vested plan provided for
substantial future payments of "compensation" plus additional amounts labeled "interest," which were a
function of market rates of interest. In 1983, the I.R.S. acceded to Albertson's request for current
deduction, under § 163, of the "interest" component of the arrangement. Pursuant to § 404, Albertson's
could not deduct the "compensation component" until such time as the recipients included it. As cash
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method taxpayers, the recipients did not include any portion of the amounts - neither the "compensation"
nor the "interest" until they received them. For 1983, the permitted "interest" deduction was $667,142.00.
In 1987, the government withdrew its ruling permitting Albertson's to take the interest deduction. This
litigation followed.
B. The 1983 Statute: Section 404
The relevant provisions, at the time Albertson's filed its 1983 tax return, were as follows: Sec. 404.
Deduction for ... compensation under a deferred-payment plan. (a) General rule.--.... [I]f compensation is
paid or accrued on account of any employee under a plan deferring the receipt of such compensation,
such ... compensation shall not be deductible under section 162 (relating to trade or business expenses) or
section 212 (relating to expenses for the production of income); but if they satisfy the conditions of either
of such sections, they shall be deductible ... (5) .... in the taxable year in which an amount attributable to
the contribution is includible in the gross income of employees participating in the plan.... (d)
Deductibility of payments of deferred compensation, etc., to independent contractors.--If a plan would be
described [as above].... [the] compensation-- (1) shall not be deductible by the payor thereof under
section 162 or 212, but (2) shall ... be deductible under this subsection for the taxable year in which an
amount attributable to the ... compensation is includible in the gross income of the persons participating
in the plan.
C. The Statute Today
The 1986 amendment to § 404 removed the statutory cross-references to sections 162 and 212,
substituting a reference to "this chapter."
Arguably, the 1983 statute merely limited section 162 and 212 deductions but not section 163 deductions
(interest); however, the argument goes, the amendment effectively limited all chapter one deductions,
which includes section 163.
As explained below, other credible explanations for the amendment exist.
D. Issues
1. In 1983, did § 404 apply to both the "compensation" and "interest"
components of a non-qualified deferred compensation arrangement? Or, did it
merely apply to the "compensation" component?
2. Were the amounts labeled "interest" actually "interest" or were they mere
additional amounts of deferred compensation?
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E. History
1. Tax Court
a. Citation: 95 T.C. 415 (1990)
b. Holding: For the Government
The majority (nine judges) held that all the amounts constituted "compensation" and none were
"interest." As a result, § 404 required Albertson's to defer deduction of the entire amount until paid.
The concurring opinion (four judges) recognized the "interest" component as "interest" but nevertheless
interpreted § 404 as applying to both the "compensation" and "interest" components of non-qualified
deferred compensation.
The dissents (five judges) believed that § 404 did not apply to the "interest" component of non-qualified
deferred compensation.
2. Ninth Circuit
a. Citation: 38 F.3d 1046 (9th Cir. 1993)
b. Holding: For the Taxpayer, reversing the Tax Court
The three judge panel decided that the amounts labeled "interest" were
indeed interest. In addition, they held that § 404, as written in 1983, did not
affect the deduction of the interest component of non-qualified deferred
compensation.
3. Ninth Circuit on Rehearing
a. Citation: 42 F.3d 537 (9th Cir. 1994)
b. Holding: For the Government, reversing its earlier opinion
All three judges reversed themselves reluctantly. They did not specifically hold that the extra amounts
constituted "interest"; however, they again acknowledge that they resemble "interest." In any event, the
court found that: "In sum, we decline to adopt Albertson's interpretation of I.R.C. s 404. Whether or not
the additional amounts constitute interest, allowing Albertson's to deduct them prior to their receipt by
their employees would contravene the clear purpose of the taxation scheme governing deferred
compensation agreements." 42 F.3d at 546 (1994).
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The court stressed its reluctance to reverse itself: "We have now changed our minds about the result we
reached in our original opinion and conclude that our initial decision was incorrect. The question is not
an easy one, however. We have struggled with it unsuccessfully at least once, and it may, indeed,
ultimately turn out that the United States Supreme Court will tell us that it is this opinion which is in
error. This is simply one of those cases--and there are more of them than judges generally like to admit-in which the answer is far from clear and in which there are conflicting rules and principles that we are
forced to try to apply simultaneously. Such accommodation sometimes proves to be impossible. In some
cases, as here, convincing arguments can be made for both possible results, and the court's decision will
depend on which of the two competing legal principles it chooses to give greater weight to in the
particular circumstance. Law, even statutory construction, is not a science. It is merely an effort by
human beings, albeit judges, to do their best with imperfect tools to arrive at a correct result."
F. Analysis
1. Willis
a. 1983 Law
(1) Literal Reading of the Code
The code generally permitted the accrual method (as it continues to) and never restricted it with regard to
interest on deferred compensation. The only restrictions applied to "compensation" deductions under
sections 162 or 212 and not to "interest" under section 163.
Arguably, however, this limited statutory application was unwise, as it permitted the employer to accrue
a deduction for the interest component of the deferred payments, while it permitted the recipient to defer
inclusion until receipt.
Such an argument is correct: that is precisely what the section then permitted. But then, that is why the
code was later amended to preclude the divergence in accounting methods. As explained below,
considerable disagreement exists regarding the way the later amendments require conformity in
accounting methods between the payor and the payee.
One view is that the section 404 and 404A amendments require deferral of the interest deduction
attributable to the deferred payments until inclusion by the recipient. I disagree. I believe section 467
requires accrual of the interest income by the recipient to match the accrual of the interest deduction by
the employer.
However, under either view, the existence of a later amendment to correct the lack of conformity in
accounting methods supports the existence of the divergence in 1983. That was a problem demanding a
solution. However, it was for Congress to amend the code to provide the solution, not for the court to do
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so. The Ninth Circuit were by reversing its Albertson's decision, effectively amended the statute prior to
the time Congress chose to do so.
(2) Custom
I would view the customary treatment of a statute relevant, though not conclusively to its meaning. I
suspect that in 1983 most taxpayers interpreted section 404 as deferring the interest component of
deferred compensation. However, significantly Albertson's and the government each agreed, in 1983, to
do otherwise. This indicates, to me, that the custom of deferral was not as entrenched as some would
have us believe.
(3) Legislative History
The Legislative History of section 404, prior to 1983, is largely silent as to its effect on interest. At the
time of the original enactment of section 404, the code was unsophisticated in its treatment of the time
value of money. Even by 1983, the rules governing this topic were in their infancy. Thus, the history of
the statutes gives us little guidance.
However, the subsequent changes in the statute are instructive of the 1983 meaning, as discussed below.
(4) Context
As explained below, other code sections denying deductions refer both to the "interest" and the
substantive components of the item involved. This at least shows that Congressional drafters know how
to specifically refer to "interest" when they want to.
(5) Economic Reality
The reason employers pay more for deferred compensation than for comparable current compensation
involves the time value of money. The difference is interest. Whether it is taxed as interest is an issue of
tax policy, discussed below.
b. Current Law
Section 467 applies to the interest component of substantial deferred compensation arrangements -- those
involving over $250,000. That is clear on the face of section 467(g). Section 467 does not apply to the
compensation portion of deferred compensation payments; that is covered by sections 404, 404A, and
419(e). This, too, is clear from the face of the statute.
At least some of the commentators discussing Albertson's have suggested that section 467 applies to
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neither the compensatory nor the interest component of deferred compensation for services if that
compensation is covered by either section 404 or 404A. They are wrong.
Section 404 (dealing with deferred compensation for employees), section 404(d) (dealing with deferred
compensation for independent contractors), section 404A (dealing with some deferred foreign
compensation), and section 419(e) (dealing with deferred welfare benefits) comprise nearly the entire
universe of deferred payments for services. I can think of no other significant forms of deferred
compensation for services that exist.
However, if the myriad anti-Albertson's commentators are correct, those provisions trump section 467 as
to both the compensatory and interest elements of deferred compensation payments. If so, then to what is
section 467(g) applied? Well, essentially nothing. Under the anti-Albertson's arguments, section 467(g)
applies only to deferred service payments not covered by sections 404 and 404A; but no such payments
exist.
To me, such a superfluous reading of section 467(g) is preposterous. The section must mean exactly what
it says: it applies to the interest component of substantial deferred compensation payments and requires
accrual of that interest by both the payor and the payee. But, if I am correct, then sections 404, 404(d),
404A, and 419(e) must trump section 467 only as to the compensation portion of payments. And that
means that most of the criticism of Albertson's is wrong, at least as to how it would apply under current
law.
I draw these conclusions from three places: the face of the statute, the legislative history, and sound tax
policy.
(1) Literal Reading of the Code
As stated above, section 467(g) clearly applies to the interest component inherent in deferred
compensation payments. Note that it does not apply to the "payments for services" themselves; instead, it
merely imputes interest "in the case of" such payments.
Thus, whenever a taxpayer defers substantial payments for services -- in such a case -- section 467
imputes interest.
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However, section 467(g) clearly does not apply to the extent that sections 404 and 404A apply. This is
consistent with the statement above, because sections 404 and 404A do not apply to "interest," but
merely to "compensation" due employees and independent contractors. This may not be entirely clear to
everyone, because sections 404 and 404A affirmatively apply to "compensation," but do not
affirmatively exclude "interest" (which could be termed compensation for the use of money). Logically,
however, (in my mind) "compensation" to employees and independent contractors refers to compensation
or payments for services and not for the use of money (interest).
My argument regarding the face of the statute is subject to the criticism that it renders the second
sentence of section 467(g) superfluous. If the first sentence of section 467(g) applies only to "interest"
and sections 404 and 404A apply only to compensation, then what is the need for the second sentence,
which causes sections 404 and 404A to trump section 467? At first blush, there would appear to be no
such need, as no overlap exists under my argument. However, I defend the second sentence of section
467(g) on the following three grounds:
1. Ordering. Situations undoubtedly will occur in which interest is disguised as compensation or vice
versa. If section 467 applies to the interest component and section 404 to the compensation component,
then some standard must be used to apportion any unclear payment. I read the second sentence of section
467(g) as sending us to section 404, its history, and its regulations for such a standard of categorization.
This will prevent double counting.
2. Emphasis. Section 467(a)(1) requires accrual of deferred rent. Section 467(a)(2) requires accrual of
interest on unpaid accrued rent. The drafters arguably meant to say -- in section 467(g) -- that "rules
comparable to the rules of subsection (a)(2) and not subsection (a)(1) shall also apply in the case of
payments for services." But, rather than saying "and not subsection (a)(1)," they added the second
sentence. It arguably says the same thing. Just as arguably, it is unnecessary because an affirmative
reference to (a)(2) does not require an exclusion of (a)(1). The sentence was not artfully drafted and is
perhaps superfluous. So what; it is not the first time that can be said of a sentence in the code. In any
event, my reading of the sentence at least gives significant effect to the first sentence; the more popular
view essentially precludes application of both sentences.
3. Cross-Reference. Awkward as it may be, the sentence is an effective cross-reference to sections 404
and 404A.
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amendment struck the references to sections 162 and 212, substituting a denial of deductions "under this
chapter."
Several commentators have stressed that section 163 (dealing with interest deductions) appears in
Chapter 1 of the Internal Revenue Code, the same chapter that contains sections 404 and 404A.
Therefore, their argument goes, Congress intended for sections 404 and 404A to deny interest
deductions, as well as ordinary and necessary business expenses and production of income expenses.
Initially, the argument appears to have merit. However, it is subject to two criticisms: one of drafting
style, and the other arising from a committee report.
1. Style. Two comparable code provisions demonstrate Congress's ability and willingness to refer to
interest separately from compensation and similar related items.
Section 457 is similar to sections 404 and 404A, except that it deals with "Deferred Compensation Plans
of State and Local Governments and Tax-exempt Organizations." But, it is critically different in its
wording:
What does this teach us about sections 404 and 404A? It shows that those sections, which refer only to
deferred compensation and not to any "other" amounts, must, as I suggest, apply only to compensation
and not to interest.
(2) Legislative History
To bolster their arguments, several commentators have mistakenly relied on a 1986 amendment to
sections 404 and 404A as evidence that the sections apply to both compensation and interest.
Section 267 also is comparable to sections 404 and 404A in that it forces related persons on the same
method of accounting as to specified items. The similarity, however, is only general. While both sections
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Prior to the amendment, sections 404, 404A, and 419 denied deductions "under section 162 (relating to
trade or business expenses) or section 212 (relating to expenses for the production of income). . . ." The
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deny deductions "under this chapter," specifically, they apply to different items. Section 267 specifically
refers to "losses," "expenses," and "interest," while section 404 specifically applies only to
"compensation." Clearly, Congress knows how to say "compensation and interest" when it wants to. Its
failure to do so with regard to section 404 suggests that it did not contemplate expanding the meaning of
"compensation" to include interest.
2. Report. The Senate Committee Report accompanying the sections 404 and 404A amendments
explains the reason for the change:
"Capitalizable compensation expenses" arise in situations governed by Idaho Power v. Commissioner. In
Idaho Power, the Supreme Court required capitalization of otherwise deductible expenses attributable to
the construction of a taxpayer-built building. The decision effectively deferred deductions by denying
them under sections 162, 212, or 167 (for short-term assets) and allowing them instead over the lives of
long-term assets under section 167.
The case, however, also could accelerate some deductions prior to the section 404 amendment. Deferred
compensation, otherwise deductible under either section 162 or section 212, was not deductible under
sections 404 or 404A until the recipient included it. That deferral could last for many years. However, if
the compensation were capitalizable, it was then deductible under section 167 or 168 over the life of the
asset to which it was attributable. At least some, if not all, deductions attributable to that depreciation
would precede the ultimate payment of the compensation. As a result, the Idaho Power capitalization
requirement sometimes accelerated the deduction for deferred compensation. According to the Joint
Committee Report, the amendment to sections 404 and 404A was intended to prevent this acceleration.
Thus, the "under this chapter" language was designed with sections 167 and 168 in mind, rather than
section 163.
(3) Sound Tax Policy
It is my observation that Congress prefers qualified deferred compensation to unqualified (the
Albertson's type), and I believe it is proper policy. In a sense, that is the general point of all those
complicated provisions dealing with qualified plans; if a plan does not discriminate and does not violate
myriad restrictions, then it receives favorable treatment. The contributor may deduct contributions
currently, the plan is exempt, and the beneficiaries may defer the reporting of income. Unqualified plans,
however, appear to be disfavored in that the contributor cannot deduct compensation until the recipient
includes it.
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But, without the Albertson's case, nonqualified deferred compensation actually would receive more
favorable treatment than would qualified deferred compensation. I cannot believe that is wise policy, let
alone consistent with Congress's intentions.
My proof of this rests in the following points:
(1) Employers pay nonqualified deferred compensation to employees they wish to benefit,
particularly highly paid employees.
(2) To the extent the employer suffers from the deferral of the deduction, the employee benefits
from the deferral of the inclusion. If the two are in the same tax bracket and use the same year, the
government should be financially indifferent as to whether policy allows current or deferred treatment.
(3) The loss to the employer and the benefit to the employee are easily calculable.
(4) Because the deduction deferral required by section 404 hurts the employer and is easily
calculable, an informed employer easily can pass it on to the employee, wiping out his benefit. The
employer simply would pay the employee less than fair compensation, if the compensation is deferred.
The discount would equal the tax detriment to the employer and the tax savings to the employee. Or, an
employer who especially wants to benefit a particular employee can refrain from discounting the deferred
compensation by the amount of the section 404 effect and can thereby mask its extra benefit to the
employee. It simply would pay the amount of fair compensation, plus interest for the deferral, with no
discount for the tax effect. Shareholders -- and the government for purposes of excessive compensation -would not likely catch on.
(5) As a result, the caps and antidiscrimination provisions affecting qualified deferred
compensation are thwarted. The employer suffers no real penalty from sections 404 and 404A. By
effectively assuming part of its employee's tax liability, the employer pays what it wants to pay and
suffers the proper net consequences. Thus, what appears to be disfavored -- nonqualified deferred
compensation -- actually is favored; it avoids all those complications (especially the caps) applicable to
qualified plans.
(6) But then comes section 467(g) and Albertson's. As a result, the employee must pay taxes
currently on the interest component of the deferred payments and the employer currently may
deduct the same amount. Again, the government is financially indifferent between this approach and a
deferral of the interest. However, under this approach, the employee suffers a true disincentive to seek
nonqualified deferred compensation. The disincentive is fair -- the employee pays taxes on interest that
really accrues -- but it is nevertheless discouraging to such compensation arrangements. And that is as it
should be.
If my reasoning is correct, why would the government want to win the Albertson's case? I think it would
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not want to, and I fear that it has not fully considered the consequences of a reversal.
c. Critique of Rehearing
My prior published arguments apply to the re-hearing opinion: I have not changed my analysis.
However, I find three aspects of the new opinion to be particularly disturbing:
1. The reference to the alleged $7 Billion cost of the original opinion. The court quoted the
government's argument that a failure to reverse would cost the taxpayers approximately $7 Billion. The
court, however, did not explain the source for this number, how it was computed, or its relevance. While
the relevance may appear obvious, I believe it is not. Congress, and not the courts, has the obligation to
consider the financial impact of a taxing statute. This is particularly true today.
Prior to the reversal, several commentators alleged that a reversal was inevitable - either in the courts or
in Congress, which apparently was already considering a clarifying amendment closing the loophole
opened by the original opinion. Since those comments appeared, however, and shortly before the reversal
was announced, Washington experienced a political earthquake. Others may disagree, but I am not
confident that the current Congress would have closed the $7 Billion loophole; to the contrary, I suspect
it would not have. This would have been a tax increase at a time when tax increases are not politically
popular. Whatever the wisdom of that economic policy, I certainly believe it is for Congress to decide,
and not for the Ninth Circuit.
2. The use of the "matching principle." Much of the court's opinion discusses the "matching principle"
and the controlling concept behind section 404 and much of the Code. This portion of the opinion is, I
believe, nonsense. It relies on several commentators - Halperin, Lokken, and Bittker, among others - for
support. Those commentators, however, did not speak of "the matching principle" as the controlling
doctrine; instead, they each used terms such as "a matching concept" to describe section 404. The
difference is critical.
"The matching principle" is the most important principle of accounting, for it requires that income and
the costs of producing that income be reported (matched) in the same year. Otherwise, an income
statement would not clearly reflect income. This is part of generally accepted accounting principles and
not necessarily tax principles. It is relevant to tax law because of the general code requirement that a
method of accounting "clearly reflect income."
It is not, however, what Halperin, Lokken, and others were speaking about. They were merely describing
the way in which section 404 matches the employer cost to the employee income. By no means is that a
"principle" of tax law. It applies in some narrow instances - such as sections 404 and 267. If a "principle"
affects this area, it is that "each taxpayer is different and one persons tax consequences do not affect
another."
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In short, there is no "matching principle" of tax law. To create one would either repeal the cash method
or the accrual method: it could certainly not permit both. Unfortunately the Ninth Circuit modified
Halperin's language from "a matching concept" to "the matching principle" - a giant change. I suspect
that somewhere in the back of the minds of the judges was some notion that "the matching principle"
exists and is very important and, after all, "principles" should be followed. I am not surprised that nonaccountants might use such flawed reasoning. I am nevertheless disturbed by it.
3. The court's reference to the unfairness of accrual by the recipients. The court asserted that if its
original opinion were to continue, then recipients of deferred compensation might be required to accrue
the unpaid interest. This, the court stated, would be unfair.
Perhaps that is true; however, I believe that is exactly the point Congress had in mind when it enacted
section 467(g) - to require otherwise cash method taxpayers to accrue the interest component of
substantial non-qualified deferred compensation. As I have argued, that would effectively discourage
such arrangements in ways that deferral of the deduction does not. So what, then, if it is unfair.
And, what about Albertsons, the litigant. Does not the court's opinion force it to defer the deduction of
interest beyond the years to which it is attributable? Does this not mean that Albertsons must accrue
income in those years (which is unpaid) but that is cannot similarly deduct incurred but unpaid expenses
used to produce that income? Isn't this just as unfair, in the exact same dollar amounts? Of course it is.
Thus the court's argument is almost humorously inane.
Also, does not the required deferral of the interest violate the very "matching principle" upon which the
court bases its opinion? Of course it does.
2. Halperin
After generally denominating my article "outrageous," "profoundly disturbing," "deeply disturbing," and
at times "ridiculous," he labels my discussion of documented legislative history (preferring his own
memory) as "revisionist," "unrealistic," "troubling," and "not believable."
His articles, however, speak for themselves, and I do not summarize them here.
II. Broader View of the Case: Effect on Statutory Interpretation
A. My View of Statutory Interpretation
I believe we should read Internal Revenue Code sections, in the context of other code sections, for what
they say. Initially, that involves a literal reading. I have no problem then examining other code sections
for consistent or inconsistent use of language and style to aid in this exegesis. Failure to do so would be,
in my opinion, irresponsible. Naturally, such comparisons are, at times, not enlightening: the best
explanation for inconsistent language may simply be that the conflicting provisions were poorly drafted.
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In such a case, a proper analysis at least would be prepared with an explanation for the reasonable
viewpoint that people are entitled to rely on law and should not be expected to ignore provisions simply
because they are troublesome.
Hence I move to a second step: an examination of documented legislative history. Although I tend to
agree with Justice Scalia in his general criticism of such authority, I believe it can nevertheless provide
some guidance for conflicting interpretations and constructions, which are each based on literal readings.
If this does not resolve the matter, I would then consider judicial opinion (known in civil law
jurisdictions as jurisprudence) as evidence of learned opinion and custom. Scholarly analysis might also
be helpful at this point.
Lastly, I would consider equity, as that is ultimately what a judge must do in difficult situations.
In my analysis, I found the Albertson's opinion to be supported by a literal reading of the statutes. I found
further support in the context of other provisions, as well as documented legislative history, judicial
opinion, and sound policy.
B. Halperin's View
Professor Halperin (Georgetown) has written extensively regarding the Albertson's decision. He
criticized my analysis, accusing me of "trying to get into the minds of legislators." While that criticism of
me is inaccurate - I just want to hold them to what they say they meant - Halperin raises some interesting
points regarding statutory interpretation.
Naturally, his articles speak best for themselves. As I understand them, he believes that we should apply
the law based on what legislators meant to say, without paying too close attention to what they actually
said - either in the statute or in published legislative history. To determine such intent he consults his
own knowledge of the legislative process and the drafters themselves. As a former Deputy Secretary and
holder of other high level Washington jobs, this is a natural methodology for him and others similarly
situated. For the rest of us, however, I believe my method is more just.
The Ninth Circuit, on rehearing, however, cited Professor Halperin as the authority to follow.
C. Geier's Views
Professor Geier (Cleveland-Marshall) has written extensively regarding legislative interpretation in the
tax field. A summary of her work is located at:
Deborah A. Geier, "Interpreting Tax Legislation: The Role of Purpose," Tax Notes, May 8, 1995, p. 822.
While not in any of her published work (at least none that I have found) her approach is well illuminated
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by comments she agreed with at the last A.A.L.S conference for tax professors (the above cited
commentary is a summary of her presentation at the conference). In a panel discussion, led by Professor
Halperin and joined by Judge Halpern (of the Tax Court Albertson's majority), she and others asserted
that tax law is not really written for the common man because it is and must be so complex. Instead, it is
written for the educated lawyers and judges, who are capable of applying the law as it was "meant to be."
As such, tax law should not be read literally and Congress should not be held to more traditional notions
of statutory interpretation.
That is an interesting philosophy, however, it is not one I subscribe to. The comments are particularly
interesting in light of their venue: the conference was held in New Orleans, Louisiana - a civil law
jurisdiction which subscribes to the world-wide majority approach that law is written for the common
man, rather than for the elite, and can be written clearly.
III. Broadest View of the Case: The Tax Treatment of Deferred but Incurred Expenses
Deferred (unpaid) expenses which have nevertheless been incurred under the "all events test" are
commonplace. No one scheme exists, however, to treat them; instead, the Code provides myriad methods
of doing so, with inconsistent results. I discuss ten of those methods, however, others exist.
●
●
●
●
●
The amount was earned on 1/1/94.
A calendar year taxpayer.
The amount to be paid is $10,000 and is due 12/31/00.
A 6.8333333% after tax annual percentage rate for all years.
A 33.33% tax rate for all years.
An annual percentage rate of 10.25% for all periods and terms.
To illustrate the relative values of the ten deduction approaches, assume the following:
●
Accounting and economic computations based on the all events test (not the tax economic performance
test) would result in a current deduction for the present value of $10,000 in seven years. That would
equal $5,050.68. In addition, accounting deductions would be appropriate for the interest obligation
accrued over time. Assuming semi-annual accrual, interest would accrue and would be deductible on the
following dates:
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The $5,050.68 initial deduction would combine with the $4,949.32 interest deduction over time to equal
the total sum of $10,000.00.
The ten tax methods for deduction of deferred payments, however, do not all conform with the
accounting and economic reality of the accruals. Thus, it is helpful to measure the relative tax benefits
resulting form the various methods. Because much of the criticism of Albertson's stems from its alleged
undue tax benefit to the taxpayer, I find some perspective in order.
A. Deduct the Future Value Currently
1. Authority: Lawyer's Title Guarantee Fund v. U.S., 508 F.2d 1 (5th Cir.
1975) appears to use this method. Ford Motor Co. V. Commissioner, 102 T.C.
87 (1994) rejects it. Also, section 461(h) generally prohibits it.
2. Example
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B. Deduct the Present Value Currently
1. Authority: Section 468 uses this method for solid waste reclamation costs. It
permits no additional amount for interest.
2. Example
C. Deduct the Present Value Currently Plus an Additional Amount When Paid
1. Authority: Section 461(h), dealing with contested liabilities, uses this
method. It unreasonably times the interest deduction; but, then, that was
congress's choice.
2. Example
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D. Deduct the Present Value Currently Plus the Interest Element Over Time
1. Authority: Section 467(a) uses this method with respect to deferred
payments for rent.
2. Example
E. Deduct the Future Value Upon Payment
1. Authority: Section 461(h) arguably uses this method, at least that is what the
regulation examples appear to imply. Treas. Reg. Section 1.461-4(g) Example
1. But see, Treas. Reg. Section 1.461-4(c), which arguably would permit
deduction of the interest element over time plus the present value upon
payment. That alternative view of section 461(h) is consistent with the original
Albertson's decision.
2. Example
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F. Deduct the Present After tax Value Currently, Fund the Amount, Exclude the
Interest Earned by the Fund (but have the fund pay taxes).
1. Authority: Section 468A uses this method for Nuclear Power
Decommissioning Costs.
2. Example
G. Deduct the Interest Component Over Time Plus the Remainder at the End
1. Authority: Section 467(g) and the original Albertson's opinion adopt this
method.
2. Example
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H. Deduct the Interest Component Over Time Plus the Future Value at the End
1. Authority: Section 453(A)(c) adopts this method in a mirror situation. I do
not suggest that it is authority for the deduction; however, a discussion of
fairness compels consideration of this approach, which is undoubtedly fair, as
demonstrated below.
2. Example
I. Deduct the Present Value Currently, Fund the Amount, Have the Fund Include the
Income From the Fund, and Have the Fund Deduct any Extra When Paid
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1. Authority: Section 468B adopts this method fro structured settlement plans.
2. Example
J. Deduct the Present Value Currently, Fund the Amount, and Make the Fund Tax
Exempt
1. Authority: Section 404 and 501 adopt this method for qualified deferred
compensation plans and arrangements.
2. Example
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