Seventh Circuit takes a pragmatic approach on accrual of recurring expenses.

• Author: Lerman, Jerry L.

In late 2001, the Seventh Circuit reversed the Tax Court in U.S. Freightways Corp., 270 F3d 1137 (2001). The taxpayer's long-haul freight trucking business incurred significant expenditures for 12-month permits, licenses and insurance premiums associated with its fleet. The taxpayer deducted these items as incurred, but the IRS argued (and the Tax Court agreed) for capitalization and amortization over the related 12-month periods.

On appeal, the Seventh Circuit held that the court had determined improperly that the accrual-method did not allow the taxpayer to deduct the expenses under a "one-year" rule. The appellate court determined that the criteria for capitalization or expensing a particular item should not turn on the taxpayer's using the cash or the accrual method, and that the taxpayer's activity with these expenditures and their future economic benefits should control. The Seventh Circuit also recognized that the timing of the deductions had nothing to do with tax planning and manipulating the economics, but reflected true business need.

U.S. Freightways had to purchase a large number of permits and pay significant fees and insurance premiums to legally operate its trucks. The licenses, permits and fees were valid for no more than 12 months. The Seventh Circuit took a common-sense approach, looking specifically at the regulations under Sec. 263 to understand the concept of capitalization when the expenditure extends "substantially beyond" the tax year.

The court recognized that, although there has never been a clear understanding of what "substantially" means, the use of a 12-month criteria may (under the right circumstances) produce a proper approach. This is true in cases such as U.S. Freightways', which has no real control over the renewal process for critical licenses and insurance coverage. Therefore, the appropriate analysis is that such recurring items have no benefit beyond the 12-,month period, and therefore do not have "substantial" longevity. Rejection of a "one-year rule" (that may have been used in dealing with cash-basis taxpayers) simply because a taxpayer is on the accrual method is unfounded. Said another way, the Seventh Circuit noted that such expenses are not suitable for amortization, given U.S. Freightways' facts.

The decision...