Deductibility of contested liabilities.

Recently, in Varied Investments, Inc., 8/2/94, the Eighth Circuit held that a contested liability was deductible under Sec. 461(f) when the taxpayer filed a bond collateralized by a pledge of U.S. government securities with an escrow agent. As part of an appeal of a state court judgment entered against Varied, a surety company issued a bond; Varied secured the bond by pledging U.S. government securities to a trust company as the escrow agent. In disallowing the deduction, the Service had argued that a transfer under Sec. 461(f)(2) did not occur because the escrow agreement was not signed by the claimant, even though the agreement expressly provided that the claimant was the beneficiary.

In reaching its holding that the entire amount of the contested liability was deductible, the court first concluded that the amount of the judgment, if it had not been appealed, would have been deductible in 1986 as an ordinary and necessary business expense under Sec. 162, thereby meeting the Sec. 461(f)(4) requirement. In addition, with respect to the Sec. 461(f)(2) requirement (dealing with the transfer of money or other property to provide for the satisfaction of an asserted liability), the court agreed with Varied that the escrow agreement did not need to be signed by the claimant to qualify under Sec. 461(f)(2). The court looked to Regs. Sec. 1.461 2(c)(1), and to two other circuit courts that had reached opposite conclusions on the issue dealing with a claimant's signature on a trust or escrow agreement. The language in Regs. Sec. 1.461-2(c) (preceded by the words "In general," lists three possible means of achieving a transfer. one effective means is a transfer of money or other property beyond the taxpayer's control to an escrowee or trustee pursuant to a written agreement (among the escrowee or trustee, the taxpayer and the person who is asserting the liability) that the money or other property be delivered in accordance with the settlement of the contest. The courts have reached differing conclusions as to the scope and interpretation of these regulations. For example, in Poirier & McLane Corp., 547 F2d 161 (1976), the Second Circuit held that the party asserting the liability must sign the escrow agreement in order for the judgment to satisfy Sec. 461(f). It should be noted that in Poirier, a "contingent liability reserve" was established in which the taxpayer had complete discretion over the timing and amounts of its transfers into the trust account.

However, in Chem Aero, Inc., 694 F2d 196 (1982), the Ninth Circuit concluded that a reasonable interpretation of the regulations is that a signature is not required because "... the statutory purpose can be fulfilled by allowing the taxpayer to take the deduction whenever the money for the settlement of the contested liability is irrevocably parted with, provided that the manner of transfer is not open to the possibility of tax abuse."

Taxpayers entering into escrow or other transfer agreements with respect to contested liabilities should be mindful of these court decisions, as well as the Service's position.