Failure to satisfy all-events test denies S corp. deductions.

• Author: Buchbinder, Elizabeth

In Jimmy D. Weaver, 121 TC No. 14 (2003), the Tax Court held that S corporation shareholders could not deduct expenses the S corporation incurred in the years claimed, because it failed to satisfy the economic performance prong of the Sec. 461(h) all-events test.

Facts

James D. Weaver owned an 80% interest in Clarkston Window & Door, Inc. (Clarkston), an accrual-method S corporation that sold construction materials at wholesale. He also owned an 80% interest in J.D. Weaver & Associates, Inc. (J.D.), a cash-method C corporation that installed windows. Clarkston is a calendar-year taxpayer, while J.D. operates on a fiscal year with a July 31 year-end.

On its 1996 return, Clarkston deducted $30,000 for professional management services received during the year from J.D J.D. included the $30,000 in its taxable income for its 1997 tax year. On its 1997 return, Clarkston deducted $63,350 for professional management services received from J.D. during that year. J.D. included the $63,350 in its taxable income for its 1998 tax year.

On their 1996 and 1997 returns, Weaver and his wife reported the deductions passed through to them from Clarkston for fees and expenses. On audit, the IRS determined that Clarkston (and thus, the Weavers) could deduct the $30,000 expense in tax year 1997, but not in tax year 1996. It also determined that Clarkston (and, thus, the Weavers) could not deduct $60,000 of the $63,350 expense in tax year 1997.

As of July 31, 1998, Clarkston had not paid J.D. $90,000 in fees and issued J.D. a note for that amount. When J.D. merged into Clarkston as part of a Sec. 368 merger, the $90,000 intercompany note was eliminated by a book entry.

In Tax Court, the Weavers argued that they were entitled to the deductions, because Clarkston had satisfied the Sec. 461(h) all-events test. The IRS disagreed, arguing that Clarkston failed the economic performance prong of the all-events test, because it did not satisfy the Sec. 404(d) timing requirement. In support of Sec. 404(d)'s application, the Service noted that (1) Clarkston owed J.D. for services rendered and (2) Clarkston and J.D. arranged to defer the receipt of compensation for those services.

Law

Sec. 461(b) permits accrual-method taxpayers to deduct expenses in the tax year in which the all-events test is satisfied. Under Regs. Sec. 1.461-1(a)(2)(i), the test is met when (1) all events establishing the fact of the liability have occurred; (2) the amount of the liability can be...