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The Fact of the Liability Requirement in the All Events Test—Flying Lessons Over the Dark Clouds of General Dynamics from a Giant Eagle

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The Fact of the Liability Requirement in the All Events Test—Flying Lessons Over the Dark Clouds of General Dynamics from a Giant Eagle THE FACT OF THE LIABILITY REQUIREMENT 635 The Fact of the Liability Requirement in the All Events Test—Flying Lessons over the Dark Clouds of General Dynamics from a Giant Eagle PHILIP G. COHEN* Abstract For taxpayers employing the accrual method of accounting, a liability is generally deductible for federal income tax purposes “in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.” The first requirement of the all events test, establishing the fact of the liability, was the subject of a thought-provoking Third Circuit decision, Giant Eagle, Inc. v. Commissioner, a case in which the taxpayer prevailed. In Giant Eagle, the dissenting judge, Thomas M. Hardiman, determined that the majority’s rea- soning contained a fatal flaw: it did not adequately address the fact that the rebate program established by the taxpayer included an expiration provision on claims not filed within a prescribed time frame. This Article utilizes Giant Eagle to analyze conditions precedent that are real versus those that are mere technicalities, the differences between conditions precedent and conditions subsequent, and the effect of waivers upon establishing the fact of the liability. Other important lessons are garnered from the examination of Giant Eagle, including overcoming the questionable decision of the Supreme Court in United States v. General Dynamics Corp. * Associate Professor of Taxation, Pace University Lubin School of Business; Retired Vice President-Tax & General Tax Counsel, Unilever United States, Inc.; B.A. New York Univer- sity; J.D. Duke University School of Law; LL.M. (Labor Law & Taxation) New York Univer- sity School of Law; M.B.A. (Accounting) George Washington University. The author thanks Michael Schler and Professor Richard Kraus for their helpful comments on an earlier draft and his graduate teaching assistant, Huirong (Helena) Tang for her assistance with the Article, as well as Professors Cynthia Pittson and Gail Whittemore of the Pace University Elizabeth Haub School of Law Library. All errors, omissions and views, however, are his own. Tax Lawyer, Vol. 71, No. 3 635 636 SECTION OF TAXATION Table of Contents I. Introduction ....................................................................................636 A. The All Events Test—Background and Overview .......................636 B. The Supreme Court’s Analysis of the Application of the First Prong of the All Events Test in United States v. Hughes Properties and United States v. General Dynamics .............................................639 II. Giant Eagle v. Commissioner .............................................................646 A. The Tax Court Decision.............................................................646 B. The Third Circuit Decision ........................................................650 C. The Third Circuit Dissent .........................................................659 D. Condition Precedent, Condition Subsequent & Waivers ...........660 III. Further Observations .......................................................................668 IV. Conclusion ......................................................................................671 I. Introduction A. The All Events Test—Background and Overview For taxpayers utilizing the accrual method of accounting, a liability is gen- erally deductible for federal income tax purposes “in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.”1 The first requirement, establishing the fact of the liability, was the subject of a thought-provoking Third Circuit decision, Giant Eagle, Inc. v. Commissioner, albeit one with a fatal flaw.2 The decision, in which the taxpayer prevailed, provides important lessons for other taxpayers including overcoming a questionable decision of the Supreme Court in United States v. General Dynamics Corp.3 Despite the taxpayer win in Giant Eagle, Judge Thomas M. Hardiman’s dissent provides further instruction about program design to which similarly situated taxpay- ers should pay heed. Prior to the enactment of section 461(h) in 1984,4 which added the eco- nomic performance requirement, accrual method taxpayers needed to satisfy a two prong all events test, now codified in section 461(h)(4), requiring that “all events have occurred which determine the fact of liability and the amount 1 Reg. § 1.461-1(a)(2)(i). 2 Giant Eagle, Inc. v. Commissioner, 822 F.3d 666 (3d Cir. 2016), nonacq. A.O.D. 2016-03, 2016-40 I.R.B. 424, rev’g T.C. Memo 2014-146 (2014). 3 United States v. Gen. Dynamics Corp., 481 U.S. 239 (1987). 4 Deficit Reduction Act of 1984, Pub. L. No. 98-369, § 91(a), 98 Stat. 494, 598 (1984) (codified as amended at I.R.C. § 461). Tax Lawyer, Vol. 71, No. 3 THE FACT OF THE LIABILITY REQUIREMENT 637 of such liability can be determined with reasonable accuracy.”5 Section 461(h) (1) added a third requirement relating to timing of the deduction by provid- ing that “the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.”6 As the Tax Court observed in VECO Corp. v. Commissioner, “An accrual basis taxpayer claiming that it incurred a liability for Federal income tax purposes must satisfy each of the three requirements under the all events test in order to claim a deduction for the liability.”7 A liability is considered to be “fixed when payment is unconditionally due or when the required performance occurs on the part of the other party.”8 The Tax Court has indicated that “[t]he purpose of . [requiring that the fact of liability be established] is to protect tax revenues by insuring that a taxpayer will not take deductions for expenditures that might never occur.”9 In determining whether this first prong of the all events test is met, generally “‘conditions precedent’ (contingencies) will prevent accrual, but ‘conditions subsequent’ will not.”10 “The [first prong of the] all-events test is not satisfied, and a liability not established, by a statistical probability—however high—that the taxpayer will ultimately pay the expense.”11 In their leading treatise, Federal Taxation of Income, Estates and Gifts, Professors Boris T. Bittker and Lawrence Lokken observed, however, that “[t]he all events standard for deductions does not make complete certainty a prerequisite to the accrual of expenses.”12 They further noted that: In commercial practice, many expenses are accrued or paid in circumstances entailing a residual possibility that the liability will be cancelled or the pay- ment refunded because, for example, the goods or services do not meet specifications or the supplier made a misrepresentation or breached a war- ranty. If accrual were postponed until these dormant possibilities evaporat- ed, any hope of matching expenses against revenues would also disappear.13 5 I.R.C. § 461(h)(4). The original all events test became part of the regulations in 1957 upon the adoption of Regulation section 1.461-1 in 1957, T.D. 6282, 1958-1 C.B. 215, 228. 6 Deficit Reduction Act of 1984, Pub. L. No. 98-369, § 91(a), 98 Stat. 494, 598 (1984) (codified as amended at I.R.C. § 461). 7 VECO Corp. v. Commissioner, 141 T.C. 440, 460 (2013). 8 George White, Accounting Methods-General Principles, 570 Tax Mgmt. Port. (BNA) § V.C.1.a (2010) (citing Rev. Rul. 80-230, 1980-2 C.B. 169; Rev. Rul. 79-410, 1979-2 C.B. 213). 9 World Airways, Inc. v. Commissioner, 62 T.C. 786, 802 (1974) (citing Mooney Aircraft, Inc. v. United States, 420 F.2d 400 (5th Cir. 1969)). 10 White, supra note 8, § V.C.1. 11 N.Y. Life Ins. Co. v. United States, 724. F.3d 256, 263 (2d Cir. 2013). 12 Boris T. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates & Gifts ¶ 105.6.3 (3d ed. 2017) (citing Reg. § 1.461-1(a)(2)(ii)). 13 See Bittker & Lokken, supra note 12, ¶ 105.6.3. Tax Lawyer, Vol. 71, No. 3 638 SECTION OF TAXATION The all events test can be traced to the seminal Supreme Court case, United States v. Anderson.14 In Anderson, corporate taxpayers, both munitions manu- facturers, kept their books using the accrual method of accounting.15 The taxpayers incurred a special profits tax on munitions manufactured by it in 1916 but not assessed and payable until 1917.16 Because income tax rates were higher in 1917 than 1916, the taxpayers wanted to deduct the tax in 1917. The Court held that the tax was deductible in 1916, not 1917, because: In a technical legal sense it may be argued that a tax does not accrue until it has been assessed and becomes due; but it is also true that in advance of the assessment of a tax, all the events may occur which fix the amount of the tax and determine the liability of the taxpayer to pay it. In this respect, for pur- poses of accounting and of ascertaining true income for a given accounting period, the munitions tax here in question did not stand on any different footing than other accrued expenses appearing on appellee’s books. In the economic and bookkeeping sense with which the statute and Treasury deci- sion were concerned, the taxes had accrued.17 In Brown v. Helvering, the taxpayer was a general agent for fire insurance companies.18 He deducted on his tax return a reserve amount that he had cal- culated from his prior experience to be a solid
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