Giant Eagle and economic performance under sec. 461(h).

• Author: Brunetti, Frank L.

EXECUTIVE SUMMARY

* Sec. 461 (h) requires that accrual-method taxpayers cannot take a deduction, even if the all-events test is met, before economic performance with respect to the item has occurred. For certain enumerated liabilities, payment--generally, to the person to whom the liability is owed--constitutes economic performance.

* Under the recurring-item exception to the economic performance requirement, taxpayers may deduct an item in the tax year before economic performance occurs if (1) the all-events test is otherwise fulfilled in the tax year of deduction, (2) the item is recurring in nature and the taxpayer consistently treats such items as incurred in the year before economic performance occurs, (3) economic performance occurs within 81/2 months after the end of the tax year of deduction, and (4) either (a) the item is not material, or (b) its accrual in the tax year of deduction results in a more proper match against income than in the year of economic performance.

* In the Giant Eagle case, a supermarket chain issued loyalty discounts for its gasoline to its customers when they made a certain amount of grocery purchases. The customers could use the discounts, which expired three months after issuance, only when they purchased gasoline.

* The taxpayer, using the recurring-item exception, took a deduction for discounts issued during the year but not redeemed at year end that it estimated it would redeem in the following year. The Tax Court agreed with the IRS that the amount of the expense for the discounts was not fixed at year end, since It was contingent upon the customers' redemption in a further purchase. Thus, the Tax Court held that the all-events test was not met with respect to the unredeemed discounts, and the taxpayer could not deduct them currently.

* On appeal, the Third Circuit overturned the Tax Court's decision, based on a theory of unilateral contract and held that the taxpayer had met the all-events test and could deduct an estimate of the amount of unredeemed discounts that would be redeemed in the subsequent year.

PREVIEW

* Review the rules for determining when an accrual-method taxpayer can deduct an expense under Sec. 461(h).

* Learn how the recurring-item exception to the economic performance requirement can allow an accrual taxpayer to deduct in the current tax year certain expenses of a recurring nature that the taxpayer pays in the subsequent year.

* Find out the approach taken by the Third Circuit in determining whether a retailer qualified for the recurring-item exception where the retailer issued discount rewards with purchases that its customers could redeem only by making another purchase from the retailer within three months.

For an accrual-method taxpayer to deduct an expense, it must meet the all-events test. This requirement did not originate in Congress. It was first articulated by the Supreme Court in Anderson, (1) where the Court said, with respect to a deduction for taxes, "In a technical legal sense it may be argued that a tax does not accrue until it has been assessed and becomes due; but it is also true that in advance of the assessment of a tax all the events may occur which fix the amount of the tax and determine the liability of the taxpayer to pay it." (2)

Under the all-events test the taxpayer has to demonstrate that both (1) all events have occurred to ensure that the taxpayer actually has had an obligation (the fact of the liability), and (2) the amount of the liability (while not necessarily precisely fixed) can be fixed with reasonably certainty. (3)

Among the changes to the determination of whether and when a taxpayer has a right to accrue a deduction made by the Deficit Reduction Act of 1984 (4) was the enactment of Sec. 461(h), which added to existing requirements for accrual tax accounting a provision that, for an amount to be incurred with respect to any item during a tax year, economic performance must have occurred with respect to that item.

Since the enactment of Sec. 461(h), the 1RS has consistently held the view that accrual-basis taxpayers have not met the economic performance requirement if all events that fix the liability for income tax purposes have not yet occurred, and that the events that fix liability include any act that must be performed by a person to whom the liability is owed. Occasionally, this has led to controversy over, for example, gift cards and discount coupons that require a further purchase by the person to whom the taxpayer issues the card or coupon. In such instances, the Service has maintained, economic performance as required under Sec. 461(h) has not occurred. In one notable recent court case, however, Giant Eagle, (5) the Third Circuit rejected the IRS's argument with respect to certain customer discounts.

This article analyzes the Third Circuit's holding and reasoning, while examining the origins and development of the IRS's position and supporting court decisions, which are nearly as old as the modern U.S. income tax itself.

In Anderson, (6) the government asserted that the taxpayer, a munitions manufacturer, should have deducted a munitions tax in 1916, when it recorded a reserve for the tax, not 1917, when it paid the tax (and the deduction was more valuable because tax rates had increased). The Supreme Court agreed, stating:

In this respect, for purposes of accounting and of ascertaining true income for a given accounting period, the munitions tax here in question did not stand on any different footing than other accrued expenses appearing on appellee's books. In the economic and bookkeeping sense with which the statute and Treasury decision were concerned, the taxes had accrued. It should be noted that section 13(d) [which authorized, subject to regulation, returns reflecting a basis of accounting other than actual receipts and disbursements] makes no use of the words "accrue" or "accrual" but merely provides for a return upon the basis upon which the taxpayer's accounts are kept, if it reflects income--which is precisely the return insisted upon by the government. We do not think that the Treasury Decision [providing guidance on then-Sec. 13(d)] contemplated a return on any other basis when it used the terms "accrued" and "accrual" and provided for the deduction by the taxpayer of items "accrued on their books." (7) Once the all-events test was satisfied, the taxpayer could deduct the full face amount of the liability.

Fact of the liability

In a number of cases prior to the Deficit Reduction Act, courts held that expenditures were deductible only when the activities that the taxpayer was obligated to perform were in fact performed, not when the "fact" of the obligation to perform was determined (see, e.g., Spencer, White and Prentis, Inc.). (8) In Spencer, a contractor constructing a subway system was required under contract to restore certain property damage. The 1RS denied the company's deductions for the accrued estimated future cost of restoration. The court held that the company had not incurred the liability for work done after the end of the tax year because it had not performed the work.

Subsequently, before the enactment of Sec. 461(h), courts reached inconsistent conclusions, allowing taxpayers to deduct the amount of a liability if all the events that fixed the liability had occurred and the amount could be determined with reasonable accuracy, even if the taxpayer did not actually perform the activities it was obligated to perform until a later year. (9)

The "Blue Book" explanation of the changes made by Congress in 1984 (10) points toward the significant revenue loss to the government by taxpayers who took accrued deductions not yet paid or performed. It noted that a deduction for a contingent liability generally was not allowed because all of the events necessary to fix the liability had not yet occurred. The Blue Book pointed out, however, that in Lukens Steel Co., (11) the court allowed the taxpayer to deduct amounts paid to a trust to fund benefits under a negotiated supplemental unemployment benefit plan, including amounts accrued in a "contingent liability account" until a targeted fund amount was reached.

Prior to the Deficit Reduction Act, the 1RS took the position that for an amount to be deductible...