Tomato processor’s accrued production costs fail all-events test

The Tax Court holds that the fact of the liabilities was not yet established to currently deduct costs to restore, rebuild, recondition, and retest manufacturing facilities.
By Charles J. Reichert, CPA

The Tax Court denied two related partnerships their claimed deductions for accrued production costs connected to their tomato products business because the partnerships had not incurred a liability under the all-events test of Sec. 461(h)(4). According to the court, the partnerships failed to establish the fact of the liabilities related to the accrued production costs that they were attempting to deduct.

Facts: The Morning Star Packing Co. LP and Liberty Packing Co. LLC (the partnerships) operated in Woodland, Calif., providing bulk tomato products to food processors and finished tomato products to food service and retail trades. Both entities were taxed as partnerships, used the accrual method of accounting, and were required to use a Dec. 31 year end for their tax returns, the same as their majority-interest partner. Both entities used a June 30 year end for financial accounting purposes.

From July to October during each tomato harvesting season, the partnerships operated their manufacturing facilities 24 hours a day. Due to the configuration of each processing plant, if any part of a production line failed, the entire facility would shut down. Also, the products produced at the facilities had to meet certain quality standards due to multiyear customer contracts and certain sanitary standards of state and federal agencies. As a result, prior to the next annual production cycle, the partnerships incurred costs to restore, rebuild, recondition, and retest (RRRR costs) the manufacturing facilities. To finance these costs and other operating costs, the partnerships had loan agreements with various banks with loan terms that required the partnerships to comply with all laws, maintain all licenses and permits, and keep all property in proper working condition.

At the end of a tax year, the partnerships estimated and added to reserve accounts the RRRR costs that would be incurred before the upcoming production cycle in the next tax year and deducted as an increase to their costs of goods sold a portion of the RRRR costs (based on the ratio of goods sold to total goods produced) on their tax returns for the current tax year.

In final partnership administrative adjustments for 2008, 2009, 2010, and 2011, the IRS decreased each partnership's costs of goods sold by a net total of $3,977,771 and $2,999,117, respectively, on the basis that the RRRR costs were deducted prematurely.

Issues: Accrual-basis taxpayers may deduct a liability in the tax year in which it is incurred. Regs. Sec. 1.461-1(a) provides that a liability is incurred when (1) all events have occurred that establish the fact of the liability; (2) the amount of the liability can be reasonably determined; and (3) economic performance has occurred related to the liability. However, for certain "recurring items," if the first two all-events tests are satisfied within a tax year, economic performance can be treated as occurring in that year if it occurs by the earlier of the timely filing of the tax return (including extensions) for that year or 8½ months after its end, and the accrual of the item in the tax year results in a better matching with income than in the tax year when economic performance occurs (Sec. 461(h)(3); Regs. Sec. 1.461-5(b)).

The fact of a liability is generally established on the earlier of: (1) the event fixing the liability, such as the required performance, or (2) the date the payment is unconditionally due (VECO Corp., 141 T.C. 440, 461 (2013)). For a liability where a taxpayer uses goods or services, economic performance generally occurs when the goods or services are provided to the taxpayer.

The IRS argued the RRRR costs were not incurred by the end of each tax year because their liability was not yet fixed and therefore not deductible until the following tax year.

The partnerships pointed to the fact that because their facilities needed to maintain sterility during production, the work to restore, rebuild, and retest was best done closer to the beginning of the next production cycle, in the next tax year. They also argued that their loan agreements and multiyear customer contracts obligated them to incur the RRRR costs, establishing the fact of their liability. Because the costs also were recurring, the partnerships claimed the recurring item exception applied.

The IRS further argued that the recurring item exception was inapplicable because the costs would be better matched with income if accrued in the year of economic performance.

Holding: The Tax Court sustained the IRS's adjustments, holding that the liability for the RRRR costs was not fixed by Dec. 31 of each tax year at issue, and therefore no deduction could be taken until the following tax year. The court rejected the partnerships' argument that the credit agreements and customer contracts obligated them to incur the production costs, thus establishing the fact of the liabilities.

The court explained that it has long held that obligations created by separate contracts, statutes, or regulations may qualify as deductible liabilities for federal income tax purposes. However, in such cases, the contracts and statutes must clearly set forth the taxpayer's obligations so that there is a sufficiently fixed and definite basis on which to base the tax accruals (see, e.g., Exxon Mobil Corp., 114 T.C. 293 (2000)).

The court found that, in the partnerships' case, the loan agreements did not identify which specific laws or regulations needed to be complied with and did not identify the specific property that had to be maintained in proper working condition; thus, the generalized obligations were not sufficient to establish the fact of the liabilities. The court further found that the customer contracts that required the partnerships to maintain certain quality standards did not establish the fact of the liabilities because "the accrued production costs in issue were for goods and services provided after the production run in each year in issue," and the RRRR costs were incurred for the next production cycle.

Since the court held that the fact of the liability had not been established, it did not address the recurring item exception.

  • The Morning Star Packing Co., L.P., T.C. Memo. 2020-142

— By Charles J. Reichert, CPA.

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