Many companies incur expenses that provide benefits in future years. A business must capitalize most of these expenditures. However, some of the expenses are annual, recurring items. The Seventh Circuit Court of Appeals recently reexamined the deductibility of these items, reversing the Tax Court.
U.S. Freightways is a trucking company that operates throughout the continental United States. Each year it incurs and pays fees for licenses, permits, insurance and other recurring items that are good only for one year. However, most of these one-year periods span two tax years. In 1993 the company paid $5,400,000 of expenses covering the 1993 to 1994 tax years. For tax purposes, it deducted the expenditures in the year paid. For financial statement purposes, it capitalized $2,985,000 of the fees—the amount that benefited 1994. The IRS denied the company’s deduction for the $2,985,000 that applied to that second year. The Tax Court upheld the IRS, and the taxpayer appealed.
Result. For the taxpayer. Deciding whether an expenditure is deductible or capitalizable has always been difficult. The Indopco decision, although clarifying that a separate asset was unnecessary, did not make the decision any easier. In the U.S. Freightways case, the Seventh Circuit reviewed all the reasons the taxpayer and the IRS provided. It accepted the fact that the expenditures in question were ordinary and necessary and would be deductible if the coverage period coincided exactly with a single tax year.
The first issue the Seventh Circuit looked at was whether a one-year rule applied. Under this rule, an expenditure always is deductible if its benefits do not exceed 12 months—regardless of how many tax years these months span. The Tax Court rejected this rule on the grounds that it applied only, if at all, to cash-method taxpayers. The Seventh Circuit, in turn, rejected this conclusion on the grounds an expenditure’s deductibility should not be based on the taxpayer’s accounting method. Whether the company is a cash- or accrual-method taxpayer, the deductibility rules should be the same.
The Seventh Circuit decided the issue should be determined based on whether or not the expenditure provided substantial future benefits. It rejected the IRS attempt to quantify “substantial” by imposing a monthly limit. (The fact that a benefit extends six months into the second tax year does not make it any more substantial than if it extends only one month.) Instead the Seventh Circuit chose to look at the annual, recurring nature of the expenditure, the amount of real distortion of income and the lack of tax planning and manipulation in the expenditure pattern to conclude the factors favored deductibility.
The IRS attempted to use against the taxpayer its financial accounting treatment of these items. The Seventh Circuit reaffirmed the accepted conclusion that tax and financial accounting have different functions and the treatment of an item under one does not determine how it would be treated under the other.
The Seventh Circuit concluded that for the particular kind of expenses at issue—fixed, one-year items where the benefit will never extend beyond that term, that are ordinary, necessary and recurring expenses for the business in question—“the balance of factors under the statute and regulation cuts in favor of treating them as deductible expenses.”
Although this decision does not establish absolutely a one-year rule, it does provide good precedent and reasoning other taxpayers can use to deduct comparable items. The major uncertainty that remains is the court’s remanding of the case to the Tax Court to consider the question of whether the company’s accounting method clearly reflects income. Although the IRS raised this issue, the Tax Court had not considered it previously.
U.S. Freightways Corp., fka TNT Freightways Corp. v. Commissioner, 88 AFTR2d 2001-5508.
Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.