Should cost of goods sold be subject to economic performance?

• Author: Tovig, Barry A.

On June 7, 1990, the Treasury issued proposed regulations under Sec. 461(h), which generally require that economic performance occure before a liability is considered "incurred" and taken into account by an accrual-method taxpayer. These regulations are significant in that they affect every taxpayer that uses the accrual method of accounting for tax purposes. The proposed regulations purport to modify the regulations under Secs. 61, 263A and 446, in an attempt to impose the economic performance standard on capitalized costs and costs of goods sold (COGS).

Specifically, Regs. Sec. 1.446-1(c)(1)(ii) states that, in addition to allowable deductions, the term "liability" includes any amount otherwise allowable as a capitalized cost, a cost taken into account in computing COGS or a cost allocable to a long-term contract. Regs. Sec. 1.61-3 would be amended by adding a sentence that provides that an amount cannot be taken into account in the computation of COGS any earlier than the tax year in which economic performance occurs. Similarly, Temp. Regs. Sec. 1.263A-1T would provide that the amount of any cost required to be capitalized may not be included in inventory or charged to capital accounts or basis any earlier than when economic performance occurs. This is merely the latest IRS attempt to achieve by regulations what the courts have denied.

The expansion of the economic performance limitation to COGS seems to ignore the distinction between deductions from gross income and those to arrive at gross income, a distinction that has long been recognized by the courts. In B. C. Cook & Sons, Inc., 65 TC 422 (1975), aff'd per curiam, 584 F2d 53 (5th Cir. 1978), the taxpayer was a fruit dealer whose employee had engaged in embezzlement by writing certain of the taxpayer's checks to a fictitious payee and then intercepting the funds. The employee had characterized the fictitious payee as a seller of fruit to the taxpayer; consequently, the taxpayer innocently included the payments in its tax returns for the years 1958 to 1965 as part of its COGS. When the taxpayer discovered the embezzlement in 1965, it claimed the entire amount embezzled as a theft loss deductible under Sec. 165. The Service disallowed the embezzlement deduction from 1958 to 1961--the years closed by statute. The Tax Court nevertheless sustained the Sec. 165 deduction in its entirety in 1965.

After the Tax Court issued its decision, the IRS served another notice on the taxpayer...