Contested liabilities - when is a deduction allowed?

In today's contentious world, it is not uncommon for a taxpayer to be involved in a lawsuit or other type of dispute, the outcome of which will be uncertain at the end of the tax year. Ordinarily, if a tax-payer disputes a liability, and is actively contesting it, no deduction is allowed. However, proper tax planning can make it possible for an accrual basis taxpayer to take a deduction before the actual settlement of the dispute.

Generally, an accrual basis taxpayer is entitled to accrue a tax deduction for a liability in the tax year in which (1) all events have occurred that establish the fact of the liability; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred for the liability. The first two requirements are known as the "all events test." When a taxpayer has a legitimate dispute as to the law or facts necessary to establish the existence or accuracy of a claimed liability, it becomes difficult to satisfy the "all events test" necessary to qualify for a deduction. The deduction is thus postponed until the dispute is settled by the parties, or final judgment is rendered by the courts. If the taxpayer admits liability to part of the claimed amount, a deduction is allowed for the undisputed portion, but a mere offer to compromise a disputed claim will not create a deduction. obviously, payment of the contested liability will also give rise to a deduction. Most often, however, these alternatives are not desirable.

Sec. 461 (f) and the related regulations provide rules for the timing of deductions for contested liabilities. If (1) the taxpayer contests an asserted liability, 2) the taxpayer transfers money or other property to provide for the satisfaction of the asserted liability, (3) the contest with respect to the asserted liability exists after the time of the transfer, and 4) but for the fact the asserted liability is contested, a deduction would be allowed for the tax year of the transfer (or an earlier tax year) subject to certain exceptions, the deduction will be allowed for the tax year of the transfer.

A contested liability arises when a taxpayer refuses to admit liability to pay an amount claimed. It is not necessary to have a formal lawsuit, only an affirmative act, whether in writing or not, denying the liability's validity and/or correctness to the person asserting the liability. For instance, a letter to the county assessor protesting a proposed real estate tax assessment constitutes a contest of an asserted liability.

A taxpayer may satisfy an asserted liability by transferring money or other property beyond his control. As stated, this transfer may be to the person asserting the liability; however, unless the asserted liability is in the nature of a tax or perhaps a regulated utility, it is not usually desirable to make such a payment. The transfer may be into an escrow or trust account (also known as a Sec. 461(f) trust or fund) under a written agreement (among the escrowee or trustee, the taxpayer and the person who is asserting the liability) effectively placing the money beyond the taxpayer's control and stipulating that the money will be delivered in accordance with the settlement of the contest. Thus, if a bank escrow account is used, the bank must be authorized to disburse the funds to the claimant or to the taxpayer depending on the final settlement of the claim, with the taxpayer relinquishing all authority over the money or other property. The same result occurs if a taxpayer provides for the satisfaction of an asserted liability by transferring the money or other property beyond his control to a court with jurisdiction over the contest.

Regs. Sec. 1.461-2(c) provides examples illustrating transfers beyond a taxpayer's control. For instance, the purchase of a bond to guarantee payment of an asserted liability or simply making an entry on the taxpayer's books are not considered adequate transfers. Also, the courts have held that claimants must agree to the establishment of a Sec. 461(f) trust. In Poirer & Maclane Corp., 547 F2d 161 (2d Cir. 1976), rev'g 63 TC 570 (1975), the taxpayer's unilateral transfer of assets to a reserve held in trust, even though the transfer placed the money beyond the tax payer's control, was not the equivalent of payment to a Sec. 461(f) trust and the deduction was disallowed. Consequently, in order to qualify for a deduction, a taxpayer may be forced to admit the accrual to the claimant in connection with establishing the Sec. 461(f) trust. This disclosure may, unfortunately, limit his negotiating power during the contest of the asserted liability.

However, the issue of deductibility, when there is a unilateral transfer beyond a taxpayer's control, remains ambiguous. The Second Circuit decision in Poirer was marked with a strong dissenting opinion and overturned the Tax Court decision, which would have allowed a deduction for the establishment of a Sec. 461(f) trust without the knowledge of the claimant. The judicial scoreboard: the Second Circuit and the Claims Court have ruled that written agreement with the claimant is required, while the Tax Court and the Ninth Circuit have ruled that such an agreement is not required. Therefore, substantial authority may exist for a taxpayer to take the deduction on a tax return without notifying the claimant of the fund's existence.

The rules provide an exception if the contested liability requires a payment to another person and arises under a workers' compensation act or under any tort. Under the economic performance rules of Sec. 461(h)(2)(c), a transfer to a Sec. 461(f) trust does not discharge the taxpayer's liability to the claimant. Economic performance occurs, and a deduction is allowed, only as the payments to the claimant are made.

Special rules under Sec. 468B and related regulations apply to determine when economic performance is deemed to occur when taxpayer makes a transfer of money or other property to a designated settlement fund (DSF) or a qualified settlement fund (QSF). Generally, DSFs are established under court order to resolve or satisfy a taxpayer's liabilities for certain claims arising out of personal injury, death or property damage. Qualified settlement funds are established under a governmental authority (but not necessarily under a court order) to resolve or satisfy a taxpayer's liabilities for certain claims arising out of environmental law; a tort, breach of contract or violation of laws; or designated in a revenue ruling or revenue procedure. The DSF provisions do not apply with respect to any liability of the taxpayer arising under any workers' compensation act or a contested liability under Sec. 461 (f). The QSF provisions may not be used to resolve or satisfy claims that give rise to certain regularly recurring liabilities. For example, a drug manufacturing company would use a DSF or a QSF for the settlement of a class action tort suit brought by purchasers of the drugs manufactured by the company.

The contested liabilities rules are complex and the interpretations of what constitutes a transfer of money or other property to provide for the satisfaction of an asserted liability are strict. However, application of the rules may serve a practical tax purpose by allowing a deduction to offset related taxable receipts. Should a taxpayer prevail in a contest, the money or other property returned will increase taxable income in the year the contest is settled (Regs. Sec. 1.461-2(a)(3)).