Accrual, cruel world - tax rules

Nation's Business, Dec, 1989 by Gerald W. Padwe

Sometimes Congress seems to take a "heads you lose, tails I win" approach to the Tax Code. The accrual method of accounting allows much more of that, and in taking up future tax legislation, Congress may well consider requiring more businesses--even service-oriented partnerships, sole proprietorships, and S corporations--to use the accrual rather than the cash method.

Claiming deductions on accrued liabilities can be tricky. The rule on deductions for accrued liabilities is that they have to be definite, not estimated, expenses. The fact of the liability has to be established by "events" that determine the amount of the liability with reasonable accuracy. This test is the critical starting point for accrual-basis deductions. But when is an event an "event"? A recent decision in a federal appeals court gave an interesting slant to the word "event," and it gave a corporate taxpayer a significant deduction before payment.

In 1980 a company settled a patent-infringement suit agreeing to pay an inventor $1,250 a month for the rest of her life, including a guaranteed payment term of 48 months. The company's tax return for that year determined its liability to the inventor by using mortality tables showing her life expectancy as 16 years, and it deducted the $240,000 that would be payable at $1,250 a month for 16 years.

The Internal Revenue Service disallowed all but the $60,000 the inventor would get in 48 months. Mortality tables doubtless are accurate for large populations, said the IRS, but not necessarily for one person; the inventor might live more or less than 16 years.

The only certainty in the agreement, as viewed by the IRS, was that 48 monthly payments would have to be made whether the inventor lived or died. In short, all "events" to fix the validity of the $240,000 deduction could not occur until the inventor had actually survived for 16 years. The proper tax treatment would be a deduction in the year of settlement for $60,000, then a deduction of $1,250 for each monthly sum paid after the 48th month.

The U.S. Tax Court disagreed with this analysis, as did the 2nd U.S. Circuit Court of Appeals. The "all events" test contains two prongs. First, all events must have occurred to establish the fact of liability--in this case, the signing of the settlement agreement dismissing the suit and obligating the company to pay $1,250 per month. The second prong requires a determination of liability with "reasonable" accuracy, not with "absolute," or "total," accuracy. The use of mortality tables in this context was "reasonable." Thus the test's two prongs are satisfied; all $240,000 is deductible.

Both courts dismissed the concept of survival as an "event" necessary to satisfy the "all events" test. An "event" changes the status quo. Since the inventor is alive, her survival in month 49 is not a change in the status quo but a continuation of it. Therefore, it would not be an "event" under the "all events" test.

In its original return, the company claimed only the present value of the $240,000 of payments over the 16 years, or $120,000.

Before the case went to the tax court, however, the corporation had changed its position and determined that no recognition need be given for the concept of the time value of money. The tax court agreed, and the IRS did not appeal that finding.

Under today's tax rules, however, the time value of money is important to accrual-basis deductions. If a similar settlement were negotiated today, the IRS would have a strong case for limiting each year's deduction to the amount paid to the inventor that year.

Gerald W. Padwe is national director-tax practice for Touche Ross & Co. Readers should see tax and legal advisers on specific cases.