Economic Performance



A business expenditure is deductible if it is ordinary and necessary as defined in IRC section 162. The “all-events test” generally determines the timing of the deduction. The Tax Court recently addressed the timing issue for services performed between related parties.

Jimmy Weaver owned 80% of the stock of Clarkston Window and Door Inc., an S corporation that filed its tax return using the accrual method and a calendar year. Weaver also owned 80% of the stock of J.D. Weaver & Associates, a C corporation that used the cash method and had a July 31 fiscal year. J.D. Weaver performed management services for Clarkston as an independent contractor. On its 1996 return Clarkston deducted $30,000 for these services; on its 1997 return it deducted $63,350. J.D. Weaver included the $30,000 as income on its 1997 return and $63,350 on its 1998 return. As of July 31, 1998, Clarkston had not paid $90,000 of these fees. It subsequently issued a note to J.D. Weaver for the unpaid amount. The merger of J.D. Weaver into Clarkston cancelled the note. The IRS ruled Clarkston could not deduct the $90,000 in the years claimed because it had never paid it. Clarkston appealed.

Result. For the IRS. Both the IRS and the taxpayer agreed the deduction should have been allowed in the year the taxpayer met the all-events test. They disagreed, however, on whether the company met the test.

Under IRC section 461(h) an event satisfies the all-events test when the liability can be established, the amount determined with reasonable accuracy and economic performance has occurred. For liabilities related to services, economic performance occurs when the services are rendered. Therefore the taxpayer argued it met the deduction requirements.

There is an exception to the conclusion that economic performance is the criterion for rendering services. Under IRC section 404, if an employee postpones compensation under a deferred-payment plan, the company may not accrue the expense unless the actual payment occurs no later than 2 1 / 2 months after the close of the business’s year. While section 404 generally applies to deferred payment plans for employee compensation, it also can apply to plans for independent contractors. In this case the IRS argued there was a deferred payment plan for independent contractor J.D. Weaver. Since payment did not take place within 2 1 / 2 months, economic performance did not occur when the independent contractor rendered the services but rather at the time of payment. In other words the taxpayer could not deduct the expenditures until it had paid them—even though it was on the accrual method.

The Tax Court agreed with the IRS that a deferral plan existed. Therefore, section 404 postponed the deduction until the company had made the payment.

This decision is a reminder that section 404 applies to both employees and independent contractors. The case left one issue open. In its conclusion the court said its holding was based on determining a deferral plan existed. Due to the special scrutiny the court gave to related-party transactions, it found this to be the case. Does this mean that if the parties were unrelated the court would not have found a plan to exist? Do deferred payment plans between unrelated parties have to be evidenced by a written contract? It will be interesting to see whether the government seeks to apply this case to unrelated parties.

Jimmy D. Weaver v. Commissioner, 121 TC no. 14.

Prepared by E dward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.


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