As the difference between ordinary income tax rates and capital gains tax rates increases, corporations have sought to minimize dividend payments to shareholders with the objective of helping them secure capital gains taxed at a lower rate. To prevent companies from doing this, Congress adopted the excess accumulated earnings tax provision of IRC section 535. Recently the Tax Court had an opportunity to consider the computation of this penalty tax.
Metro Leasing and Development Corp. filed its 1995 tax return showing a liability of $2,674, which it paid in March 1996. The IRS audited Metro’s return and after modifying the company’s deductions for officers’ salaries, determined it had not paid enough tax. It also found Metro was subject to the accumulated earnings penalty tax. Metro disagreed and filed suit in Tax Court. The company paid the disputed amount but continued its suit. The Tax Court held for the IRS on both the compensation and accumulated earnings tax issues. It required the parties to compute the new tax liability based on the corporation’s holdings under the court’s rule 155. The parties disagreed on the correct tax computation and instituted the current case to determine the right amount.
Result. For the IRS. The base for the accumulated earnings penalty is accumulated taxable income. A corporation determines this amount by adjusting its taxable income for “economic items” to better reflect how much cash it has available to make dividend distributions. The adjustments include a deduction for federal income taxes paid; charitable contributions and any net operating losses are added back. Metro disagreed with the IRS computation of the income tax deduction. The company had sold property in 1995, reporting the gain on the installment method. Metro argued the full tax liability on the gain was a current deduction even though part of the tax had been postponed until the company collected the remainder of the sales price.
The taxpayer based its argument on section 535(b)(1), which says a deduction is permitted for federal income taxes accrued during the year. The court agreed with the IRS that the taxpayer’s interpretation was incorrect. Accrued means tax actually payable based on reported income, not tax based on income a corporation would include if it reported all items of income and deductions under the accrual method. Therefore, in computing its accrued tax, Metro would include only the current year’s reported installment income.
The second issue in dispute was the contested deficiency the taxpayer paid. Metro argued the amount was deductible in arriving at its accumulated taxable income. It cited J.H. Rutter Rex Manufacturing Co. v. Commissioner in which the Fifth Circuit Court of Appeals reversed the Tax Court and held that paid deficiencies were deductible even though contested. The IRS argued that a contested liability is nondeductible regardless of payment. The Tax Court decided not to follow Rutter Rex. While the law allows a deduction for accrued taxes, a contested liability is not accrued because it does not meet the requirements of the all-events test for current recognition. Therefore Metro could not deduct these taxes even though it paid them.
This decision clarifies that the deduction for federal income tax is based on the tax accrued on the income a taxpayer reports under its accounting method. It also reopens a controversy about contested liability. Future litigation will be needed to settle the issue.
Metro Leasing and Development Corp. v. Commissioner 119 TC no. 2.
Prepared by Edward J. Schnee, CPA, PhD, Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.