Contested liabilities - when is a deduction allowed?

• Author: Connealy, Paul J.

In today's contentious world, it is not uncommon for a taxpayer to be involved in a lawsuit or other type of dispute, the outcome of which will be uncertain at the end of the tax year. Ordinarily, if a tax-payer disputes a liability, and is actively contesting it, no deduction is allowed. However, proper tax planning can make it possible for an accrual basis taxpayer to take a deduction before the actual settlement of the dispute.

Generally, an accrual basis taxpayer is entitled to accrue a tax deduction for a liability in the tax year in which (1) all 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 for the liability. The first two requirements are known as the "all events test." When a taxpayer has a legitimate dispute as to the law or facts necessary to establish the existence or accuracy of a claimed liability, it becomes difficult to satisfy the "all events test" necessary to qualify for a deduction. The deduction is thus postponed until the dispute is settled by the parties, or final judgment is rendered by the courts. If the taxpayer admits liability to part of the claimed amount, a deduction is allowed for the undisputed portion, but a mere offer to compromise a disputed claim will not create a deduction. obviously, payment of the contested liability will also give rise to a deduction. Most often, however, these alternatives are not desirable.

Sec. 461 (f) and the related regulations provide rules for the timing of deductions for contested liabilities. If (1) the taxpayer contests an asserted liability, 2) the taxpayer transfers money or other property to provide for the satisfaction of the asserted liability, (3) the contest with respect to the asserted liability exists after the time of the transfer, and 4) but for the fact the asserted liability is contested, a deduction would be allowed for the tax year of the transfer (or an earlier tax year) subject to certain exceptions, the deduction will be allowed for the tax year of the transfer.

A contested liability arises when a taxpayer refuses to admit liability to pay an amount claimed. It is not necessary to have a formal lawsuit, only an affirmative act, whether in writing or not, denying the liability's validity and/or correctness to the person asserting the liability. For instance, a letter to the county assessor protesting a proposed real estate...