When to Deduct Annual Expenditures

Many corporate taxpayers incur expenditures that provide a benefit in both the current and the following tax year. For accounting purposes, a company would simply allocate the expenses between the two periods. The tax treatment, however, is less certain.

IRC section 162 permits taxpayers to deduct all ordinary and necessary expenditures. IRC section 263 requires taxpayers to capitalize these expenditures if they provide a substantial future benefit. Based on these rules, can a company deduct expenses in the year it pays them or is it required to capitalize some portion of them?

USFreightways Corp. hauls freight throughout the United States. The company uses the accrual method of accounting and a calendar yearend. In 1993, it paid $4,308,000 for licenses, permits and fees that covered part of 1993 and 1994. It also paid $1,090,000 for insurance coverage that ran from July 1, 1993, to June 30, 1994. For “book” purposes, USFreightways deducted $1,869,500 of the fees and $545,300 of the insurance in 1993 and the remainder in 1994. For tax purposes, the company deducted all of the expenditures in 1993. The IRS determined that the company must allocate the expenditures between 1993 and 1994. The company appealed.

Result. For the IRS. Before considering the deductibility of the expenditures, the Tax Court looked at whether the taxpayer could treat the items differently for tax and book purposes. As a general rule, the IRC says, a taxpayer must file its return based on its books and records. The regulations imply that some variation is acceptable. The courts have allowed a difference if

• The taxpayer meets other IRC requirements, such as those in sections 162 and 263, for example.
• The results clearly reflect the entity’s income.

The Tax Court considered whether USFreightway’s expenditures met the requirements of sections 162 and 263 to be currently deductible. The company argued that section 263 does not require capitalization of an expenditure unless it provides a benefit substantially beyond yearend. U.S. Freightway interpreted that to mean a benefit that lasts more than 12 months beyond yearend. The court rejected this argument, saying nothing in the regulations or in the U.S. Supreme Court’s Indopco decision requires the benefit to extend beyond one year before it is capitalized. Instead, these precedents require capitalization of all expenditures that produce a substantial benefit beyond the end of the current tax year.

USFreightways tried to argue that the courts previously accepted a one-year rule in cases such as Zaninovich (616 F.2d 429, rev’g 69 TC 605, 1978). The Tax Court rejected this argument as well. The one-year rule in the cited cases applies to cash-method taxpayers, not ones using the accrual method.

Since USFreightways could not prove that sections 162 and 263 sanction deductibility of the expenses, the court did not even address the issue of whether the company’s accounting method clearly reflected its income. Its conclusion was broad enough to apply to all accrual-method taxpayers and all expenditures whose benefits extend beyond the end of the current tax year. Accrual-method taxpayers must capitalize all expenditures that provide a substantial benefit beyond yearend. The fact that the expenses are recurring is immaterial. Likewise, there is no 12-month rule for accrual-method taxpayers.

USFreightways Corp. v. Commissioner, 113 TC no. 23.

—Prepared by Edward J. Schnee, CPA, PhD,
Joe Lane Professor of Accounting and director, MTA program,
Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.