Economic performance.

• Author: Nellen, Annette
• Position: Part 2

It's Only Part of the Picture

In 1992, final regulations under Sec. 461(h), the economic performance rules, were issued. Because economic performance is only part of the picture in determining when an accrual method taxpayer may treat an item as incurred, with this picture now complete, taxpayers can deal with the entire framework and how it may have changed in light of the economic performance regulations.

This article explains the sequence of steps an accrual method taxpayer must take to determine whether an item has been "incurred." The flowchart on pages 260-261, a simplified version of the rules of Sec. 461 and its regulations, shows how an accrual method taxpayer deals with the question, "When is a liability incurred?" Steps 1 through 6 were covered in Part I, published in April. Steps 7 through 10 are analyzed below.

Sec. 461 Analysis

* Step 7: Have all the events occurred that establish the fact of the liability?

This is the first prong of the all events test at Regs. Sec. 1.461-1(a)(2) and is often referred to as the "fixed" part of the test. The purpose of this requirement, according to the Tax Court in World Airways, "is to protect tax revenues by insuring that a taxpayer will not take deductions for expenditures that might never occur."(33) For example, an estimated liability, such as a warranty reserve, is not considered fixed because it represents the cost of events that have not yet occurred (and might never occur).(34)

To meet this prong, the liability must be "final and definite in amount," "fixed and absolute" and "unconditional."(35) The approach is to identify all the events that must occur before the taxpayer actually has a fixed and absolute liability and determine if they have all occurred by the end of the tax year. If any events have not yet occurred, the next determination is whether the remaining events are merely ministerial acts that do not affect the fact that the taxpayer owes a liability. The existence of any contingency that may result in there actually being no liability will prevent a taxpayer from meeting the first prong. If the potential for payment is "too contingent" it does not "justify tax recognition."(36) Finally, a liability that the taxpayer is contesting is generally not considered fixed because the taxpayer has not admitted liability.

Application of the first prong of the all events test is not always easy and the result often differs from that derived under generally accepted accounting principles (GAAP). The problems and confusion in applying the first prong are easily illustrated by court decisions. For example, in the General Dynamics(37) case, both the Claims Court and the Federal Court of Appeals found that the taxpayer had met the first prong, but the Supreme Court reversed that finding, with three justices dissenting.

The terms and special rules necessary to determine whether all events have occurred that fix the fact of a liability are illustrated by the examples below. Note that the specific terms of any agreement or contract between the taxpayer and the payee are important in determining whether the first prong has been met.(38)

Event identification and ministerial acts: In General Dynamics, the filing of a medical claim by an employee was not viewed as a ministerial act in determining whether the employer's liability under a self-insured medical plan was fixed at year-end. The Supreme Court found that if no claim was filed, the employer had no liability; thus, the filing of a claim was a condition precedent (a necessary event) to the taxpayer having a definite liability to pay. The Court stressed that there was no certainty that all employees who received medical care would submit claims due to procrastination, confusion or fear of disclosing a medical problem to the employer. Without the filing of a claim, the corporation's liability to pay the medical expenses would never occur. In contrast to the events in General Dynamics, see the following example.

Example 10: Corporation T hires R Company to recycle T's office products. The contract specifies that the fee is $500 per month payable on the last day of each month and that R is to issue a report to T on what was recycled. Since the contract specifically calls for a fee with no requirement that the amount is owed only if T receives the report, receipt of the report is a ministerial act that does not affect the fact that T has a fixed liability each month.

Thus, a ministerial act is an event, such as paperwork, that does not affect the fact that a liability exists Under the terms of the taxpayer's agreement, even if the paperwork is not done. In General Dynamics, no obligation existed if the employee failed to file a claim form, while for T, in Example 10, a liability existed even if no report was filed. Similarly, in Challenge Publications,(39) a contract stated that a customer had to provide certain proof to the taxpayer, a magazine publisher, of the number of unsold magazines in order to obtain a refund. The court held that such notification was not a ministerial act because no liability existed without such notification.

Conditions: In Burnham Corp.,(40) as the result of a patent infringement suit, the taxpayer agreed to pay the plaintiff a set amount per month for 48 months, and longer if the plaintiff survived beyond that time period. Burnham used life expectancy tables to determine the amount of the liability and deducted it in the tax year in which the suit was settled. The Service argued that all events necessary to establish the fact of the liability had not been met, due to the uncertainty as to whether the plaintiff would live longer than 48 months. However, because the court did not view that uncertainty as an "event," it could not have an impact on whether the liability was fixed. The court defined an event as a change in the status quo and the plaintiff's survival was a continuation of the status quo rather than a change in it. The settlement of the lawsuit established the fact of the liability and the payment period did not change the fact that the taxpayer had a liability. Thus, the plaintiff's life expectancy, which would affect the total amount of the liability, was merely a condition subsequent to the establishment of an absolute liability to pay and the liability was fixed. In contrast, a requirement for a form to be submitted before a liability is owed, as in the General Dynamics case, would be a condition precedent and the liability could not be fixed until the condition was satisfied.

Tax liabilities: State income taxes are generally considered fixed in the year to which the tax relates. This is generally true even if the tax is paid later as the result of an audit.(41) To know when property taxes are considered fixed, the terms of the law must be reviewed and the lien date and assessment date determined. For example, if personal liability attaches on the assessment date, that is the date the liability is fixed. If no personal liability attaches (often the case with real property taxes), the date a lien attaches to the property (lien date) is generally the date the liability is considered fixed.(42) The liability for interest on a Federal tax deficiency resulting from a later redetermination of the tax is fixed in the year the deficiency is determined.(43)

Taxes, other than creditable foreign taxes, are a payment liability under the economic performance rules. Thus, assuming the all events test is met, the timing of the deduction can generally be controlled through the tax payment date and the return filing date.

Example 11: M is an accrual method, calendar-year taxpayer. The lien date for M's real property taxes of $100,000 is Dec. 31, 1993. The taxes are owed ratably on Apr. 1, 1994 and Nov. 1, 1994, covering the period July 1, 1993 through June 30, 1994. Because the lien date is in 1993 and the amount of taxes is known, M has met the all events test in 1993, but will not meet the economic performance requirement until the taxes are paid. If M has adopted the recurring item exception for property taxes and files its 1993 return after it pays the Apr. 1, 1994 installment, $50,000 would be deductible in 1993. If M instead filed its 1993 return before paying the taxes, the taxes would be deductible in 1994, assuming they are paid within 1994. If M wants to increase its deductions for 1993, it should consider paying the November installment before filing its 1993 return (and within 8 1/2 months after 1993). If M wants to decrease its deductions for 1993, it should either file the 1993 return before Apr. 1, 1994 or delay payment of that installment (being aware, though, that the jurisdiction would likely assess penalty and interest). If M had made an election under Sec. 461(c), the real property taxes would be deducted ratably over the period they cover, resulting in deductions in 1993 and 1994.(44)

How specific must the liability be? The first prong of the all events test can be met even though the identity of the payee or the exact payment date is not yet known. For example, in the Hughes Properties(45) case, the Supreme Court held that the taxpayer, the owner of a casino, met the first prong of the all events test with respect to its liability to eventually pay the jackpot on a progressive slot machine, every time the machine was played. The Court found the state gaming law governing the payment of jackpots to be strict enough to fix the casino's liability even before the jackpot was actually won. Under such circumstances, the existence of the liability to pay the jackpot sometime in the future was no less fixed just because the identity of the winner and the due date were not yet known.

Fixed versus legally binding. In Burlington Northern Railroad Co.,(46) the calendar-year taxpayer paid its employees twice a month. Employees were paid for the last 15 days of the calendar year on the following January 15. Once the employees performed the work, Burlington became...