The Ninth Circuit Court of Appeals recently heard a case relating to the deductibility of a paid but contested tax liability from a business’s accumulated taxable income. At the time, the rate of the penalty tax was 39.6%. Metro Leasing and Development Corp. and the East Bay Chevrolet Co. (collectively “Metro”) paid a 1995 contested tax liability in 2001 based on their calculation of the accumulated earnings tax. Metro argued that, based on IRC section 535(b)(1), the payment of the contested tax liability should be deductible from the 1995 accumulated taxable income. To support its argument, Metro noted the Fifth Circuit’s decision in J. H. Rutter Rex Mfg. Co. v. Commissioner , which held contested deficiencies that had been paid before legal resolution were deductible.
Metro’s 2001 payment, made while its case was still pending before the Tax Court, was intended to cover any deficiency it might owe for 1995. Pursuant to Tax Court rule 155, both parties submitted proposed computations of Metro’s accumulated earnings tax for 1995. Metro’s computation deducted the 2001 payment; the commissioner’s did not. Metro’s appeal required the Ninth Circuit to decide if a paid but still contested income tax deficiency could be deducted from accumulated taxable income under IRC section 535(b)(1).
Result. For the IRS. The Ninth Circuit said the question was purely one of statutory interpretation. The Ninth Circuit disagreed with the Fifth Circuit’s holding that the language of IRC section 535(b)(1) was unambiguous and permitted tax reduction for federal tax “accrued” during the year.
The Ninth Circuit determined that Metro’s 1995 tax liability, paid in 2001, did not qualify as “accrued.” In United States v. Anderson the U.S. Supreme Court held that, before an expense becomes deductible, “all events” that fix the amount and the taxpayer’s unconditional obligation to pay must have occurred. In general an accrual basis taxpayer may not deduct an expense until (1) all events have occurred that determine the fact of liability, (2) the amount of liability can be determined with reasonable accuracy and (3) economic performance or payment has occurred. When a taxpayer contests a tax liability in court, the “all events” test is not satisfied until the legal challenge is resolved because, until then, the amount of the liability and the obligation to pay it are not certain.
The Ninth Circuit held that IRC section 535(b)(1) should be interpreted in accordance with the long-standing meaning of the word “accrual.” Therefore, Metro’s 1995 paid but contested tax liability did not accrue in the taxable year assessed. Instead, it either accrued in 2001 when it was paid or will accrue when the appellate review concludes. The Tax Court did not address whether IRC section 461(f) might apply to permit a deduction in 2001, the year of payment. Therefore, the Ninth Circuit expressed no opinion as to which of these alternate views was correct.
The accumulated earnings tax rate is only 15% for tax years 2003 through 2008, so the imposition of the penalty is less onerous at this point. However, the timing of this deduction may be important for many corporations whose pre-2003 years still might be audited. Taxpayers and their tax professionals should consider these opinions when planning the payment of the penalty tax prior to a court decision. The split between the Fifth Circuit and the Ninth Circuit may require a determination by the Supreme Court.
Metro Leasing and Development Corporation , 376 F3d 1015 (CA-2).
Prepared by Ronald R. Hiner, EdD, professor of accounting and Darlene Pulliam, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.