Tax Court expansively interprets clear-reflection-of-income standard.

A recent opinion reviewed by the full Tax Court upheld an IRS determination that a taxpayer's accounting method did not clearly reflect income (Ford Motor Co., 102 TC No. 6 (1994)). The court also found that the Service did not abuse its discretion in making this determination, even though the taxpayer's method was otherwise permitted under the Code and regulations. The issue was whether Ford could deduct the full amount of future payments under 1980 settlement agreements for tort liabilities in the tax year the agreements were executed. The basis for the deduction was that the all-events test (before enactment of Sec. 461(h) in 1984) had been satisfied. The Tax Court held that the deduction should be limited to the amount Ford paid to purchase single-premium annuity contracts to fund the liabilities. In reaching this decision, the Tax Court is apparently requiring an accrual-method taxpayer to use time-value concepts to measure accrual-method deductions for pre-July 18, 1984 transactions.

Facts

In 1980, Ford executed 20 settlement agreements with tort claimants under which it was obligated to make a series of payments over various periods, the longest being 58 years. It funded the series of payments with single-premium annuity contracts. The present value of the settlement payments to be made did not exceed the amounts Ford paid for the annuity contracts. On its 1980 return, Ford claimed a deduction for the full (i.e., nondiscounted) amount of all payments to be made under the settlement agreements executed in 1980. The IRS disallowed deductions beyond the cost of the annuity contracts, under the theory that Ford's method of accounting for the settlement amounts did not clearly reflect income.

All-events test

For pre-July 18, 1984 transactions, Regs. Sec. 1.461-1(a)(2) provides that an expense is deductible by an accrual-method taxpayer for the tax year in which (1) all the events have occurred to establish the fact of the liability and (2) the amount of the liability can be determined with reasonable accuracy. The Tax Court assumed the all-events test was satisfied for the payments to be made under the settlement agreements. Ford argued that because deducting the full amount of the future payments under the agreements was a method of accounting authorized by the Code and regulations, such method clearly reflected income. The Tax Court responded that Sec. 446 provides that a taxpayer's ability to use one or more of the methods of accounting listed in Sec. 446(c) is contingent on that method clearly reflecting income. What is unclear is the extent to which the Service might try to use the Tax Court's opinion to assert the position that the clear-reflection-of-income requirement can be used to override a method of accounting specifically allowed.

Time value of money and the 1984 legislation

The Tax Court's holding that Ford's method did not clearly reflect income is rooted in the premise that the significant length of the time for the payout caused a distortion between the amount of the deduction and Ford's economic obligation. It somewhat dismissed the long-standing basic principle that an accrual-method taxpayer properly deducts a liability in the year in which the liability is incurred, regardless of when it is paid. The Tax Court opinion does not provide any guidance as to how much time must pass between incurring a liability and its payment to create a purported distortion of income on deduction of that full liability.

Apart from isolated and unusual cases such as Mooney Aircraft, Inc., 420 F2d 400 (5th Cir. 1969), time-value-of-money concepts did not play a role in the use of the accrual method of accounting for Federal tax purposes before the Tax Reform Act of 1984 (TRA). Sec. 461(h)(2)(C)(ii), added by the TRA, addresses time-value-of-money concerns by requiring tax-payers to use the cash method for payments made in settlement of tort and worker's compensation liabilities occurring after July 18, 1984.

The Ford Motor opinion is novel in its application of the time-value-of-money standard to pre-1984 liabilities. Its potential breadth in applying the Sec. 461(h) economic-performance principles to pre-July 18, 1984 transactions to satisfy the clear-reflection-of-income standard remains to be seen.