Deducting deficiency interest expense in the proper tax year.

• Author: Zaleski, Andy

Taxpayers under IRS examination often face many challenges, including responding to information document requests under tight time constraints, dealing with technical issues, locating and obtaining documentation from various company locations, managing limited resources, and negotiating proposed adjustments. Indeed, taxpayers may become so focused on closing the audit that they often overlook a potentially significant deduction.

Example: X is a calendar-year taxpayer under federal income tax examination for years 2005-2007. On December 15, 2009, X receives Form 5701, Notice of Proposed Adjustment, for certain changes to its federal taxable income for the years under examination. X reports on the accrual method of accounting for federal income tax purposes. On December 31, 2009, X indicates that it is in agreement with the proposed changes and signs Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment. As of May 15, 2010, the IRS has yet to sign Form 870, and X has not yet paid the IRS the amount of tax deficiency and related deficiency interest. Is the liability for deficiency interest fixed for federal income tax purposes as of December 31, 2009, thereby allowing the taxpayer to deduct the interest assessed?

The Law

Under Sec. 461(a), a deduction is allowed in the proper tax year under the method of accounting used in computing a taxpayer's income. Regs. Sec. 1.461-1(a) (2)(i) provides that under the all-events test of the accrual method of accounting:

* A liability for an expense accrues in the year in which all the events have occurred that establish the fact of liability for the expense;

* The amount of the liability can be determined with reasonable accuracy; and

* Economic performance has occurred with respect to the liability.

The Tax Court explained in Hallmark Cards, Inc., 90 T.C. 26 (1988), that "[t]he all-events test is based on the existence or nonexistence of legal rights or obligations at the close of a particular accounting period, not on the probability--or even absolute certainty--that such right or obligation will arise at some point in the future." The Supreme Court, in Dixie Pine Products Co., 320 U.S. 516 (1944), stated that all events are not fixed "where the liability is contingent and is contested by the taxpayer."

Regs. Sec. 1.461-2(b)(2) defines a contested liability as a liability subject to any contest that would prevent its accrual under Sec. 461(a)...