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Morning Star Packing Company, L.P. v. Commissioner (T.C. Memo. 2020-142)

On October 14, 2020, the Tax Court issued a Memorandum Opinion in the case of Morning Star Packing Company, L.P. v. Commissioner (T.C. Memo. 2020-141). The issues before the court in Morning Star Packing Company, L.P. were whether the accrued production costs were: (1) fixed and binding where economic performance did not occur until the year following the tax year claimed for and (2) whether the partnerships’ inclusion of such production costs in COGS for the years in issue resulted in a more proper match against income than inclusion in the taxable year in which economic performance occurred under the IRC § 461(h)(3) recurring items exception to the all events test.

Background

The petitioners are in the tomato business. In fact, the petitioners provide approximately 40% of the United States’ tomato paste and diced tomatoes. My seven-year-old son accounts for approximately a quarter of that market, on account of the volume of ketchup he consumes each year.  The Tax Court goes through the economics and life cycle of a tomato and its farmer.  Suffice it to say, the petitioners are busy as hell when the crop is picked on account of the tomatoes’ poor shelf life.

During the years in issue the partnerships entered into several credit agreements with domestic and foreign lenders for the partnerships’ general business purposes and working capital. The amount of credit available to the partnerships during the years in issue pursuant to these collective credit agreements ranged between $90 million and $260 million.

Costs of Goods Sold (COGS)

The costs in issue are costs to restore, rebuild, and retest the manufacturing facilities for use during the next production cycle. The accrued production costs include amounts to be paid for goods and services. The partnerships maintain reserves that they refer to as production accrual accounts. These reserves are used to account for future costs associated with restoring, rebuilding, and retesting the manufacturing facilities for use during the next production cycle.  The production accrual accounts included amounts for production labor, boiler fuel, electricity, waste disposal, chemicals and lubrication, production supplies, repairs and maintenance, lease, production wages, and administration wages.

The IRS’s Determinations

The IRS determined that neither petitioner was entitled to increase its COGS for the amount of accrued production costs because (1) the partnerships had not shown that all events had occurred to establish the fact of the liabilities, and (2) economic performance had not occurred with respect to the liabilities to qualify for accrual for the years claimed.

Specifically, the IRS contends that the accrued production costs that the partnerships included in COGS for the years in issue were: (1) not fixed and binding until the following tax year when the partnerships began economic performance and (2) more properly matched against income for the taxable year in which economic performance occurred under the IRC § 461(h)(3) recurring items exception to the all events test.

The partnerships disagree.

The All Events Test

IRC § 461(a) provides that a deduction must be taken for the proper taxable year under the taxpayer’s method of accounting. Generally, an accrual method taxpayer may deduct expenses for the years in which the taxpayer incurred the expenses, regardless of the actual payment dates. IRC § 461(h)(4); Caltex Oil Venture v. Commissioner, 138 T.C. 18, 23 (2012); Treas. Reg. § 1.461-1(a)(2). The all events test governs whether a business expense has been incurred to permit its accrual for tax purposes. See Challenge Publ’ns, Inc. v. Commissioner, T.C. Memo. 1986-36, aff’d, 845 F.2d 1541 (9th Cir. 1988). Liability is incurred under the all events test if three factors are met: (1) all of the events that establish the fact of the liability must have occurred, (2) the amount must be able to be determined with reasonable accuracy, and (3) economic performance must have occurred. IRC § 461(h)(4); Treas. Reg. § 1.461-1(a)(2); Treas. Reg. § 1.461-4 (explaining economic performance).

“Liability” refers to any item allowable as a deduction, cost, or expense for Federal income tax purposes. Treas. Reg. § 1.446-1(c)(1)(ii)(B). Thus, the production costs reflected in the partnerships’ COGS come within this definition. To be deductible, a liability must be fixed, absolute and unconditional. See Brown v. Helvering, 291 U.S. 193, 201 (1934); Lucas v. N. Tex. Lumber Co., 281 U.S. 11, 13 (1930).

A liability may not be deducted if it is contingent upon the occurrence of a future event. See Lucas v. Am. Code Co., 280 U.S. 445, 452 (1930). Generally, the fact of a liability is 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. & Subs. v. Commissioner, 141 T.C. 440, 461 (2013).

The IRS’s Arguments

The IRS contends that the accrued production costs consisted of bilateral contracts for goods and services to recondition the partnerships’ manufacturing facilities that were provided to and paid for by the partnerships after the December 31 close of their tax year. The IRS argues that all events had not occurred during the years in issue to establish the fact of the liabilities for the accrued production costs. The petitioners-partnerships contend that IRS’s focus on the bilateral goods and services contracts is misplaced. Instead the partnerships argue that their credit agreements and multiyear contracts to supply customers with tomato products obligated them to incur the accrued production costs to restore, rebuild, and retest the manufacturing facilities.

Generalized Obligations not Enough

Obligations created by separate contracts, statutes, or regulations may qualify as deductible liabilities for Federal income tax purposes. Exxon Mobil Corp. v. Commissioner, 114 T.C. 293, 318-319 (2000); Ohio River Collieries Co. v. Commissioner, 77 T.C. 1369, 1370-1371 (1981). In such cases the contracts and statutes must clearly set forth the taxpayer’s obligations so as to provide a sufficiently fixed and definite basis on which to base the tax accruals sought. Exxon Mobil, 114 T.C. at 317-318.

The credit agreements involved in these cases do not specifically set forth the partnerships’ obligations to provide a comparably sufficiently fixed and definite basis. Instead the credit agreements include nonspecific text and generalized obligations. The agreements merely require that the partnerships maintain all material licenses, permits, and governmental approvals comply with all laws, and keep all property useful and necessary in its business in good working order and condition. The credit agreements neither specify which laws or regulations must be complied with nor identify exactly which property must be kept in good working order.

Accordingly, the Tax Court concluded that the generalized obligations found in the credit agreements do not establish the fact of the partnerships’ liabilities for the accrued production costs for the years in issue. Further, because of the Tax Court’s holding that the liabilities for the accrued production costs were not fixed in the years in issue, we need not address the partnerships’ arguments regarding the recurring items exception under IRC § 461(h).

(T.C. Memo. 2020-142) Morning Star Packing Company, L.P. v. Commissioner

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