USFreightways supports IRS no "one-year rule" stance.

In the recent decision in USFreightways Corp., 113 TC No. 23 (1999), the Tax Court, for the first time, specifically addressed whether a one-year rule exists for determining whether a payment is a capital expenditure or a deductible expense. The court concluded that there is no one-year rule, and appears to have established different capitalization criteria for cash- and accrual-method taxpayers. Tax practitioners should assess the possible effect of this holding on their clients.

A number of practitioners contend that the touchstone for determining whether a payment is a capital expenditure is whether it creates a benefit with a duration in excess of one year; a payment that creates a benefit with a duration of one year or less is a deductible expense. On the other hand, the IRS contends there is no one-year rule and has begun to challenge deductions for prepayments.

In USFreightways, an accrual-basis, calendar-year taxpayer that transports freight by truck was required under state and local laws to pay for various licenses. USFreightways paid $4.3 million for licenses in 1993; none of the licenses had a duration in excess of one year, but some had an effective period extending into 1994. USFreightways also paid $1 million for liability and property insurance coverage in 1993, covering the one-year period July 1, 1993-June 30, 1994. For book purposes, USFreightways deducted the cost of the licenses and insurance ratably over the periods to which they related. For tax purposes, it deducted the cost of the licenses and insurance in the payment year. The Tax Court held that USFreightways was not entitled to deduct the license and insurance costs in the payment year, but should have deducted them ratably over the tax years to which they related.

The Tax Court concluded that the duration of a benefit beyond the current year (and not whether the duration of the benefit exceeds one year) is critical in distinguishing between capital expenditures and deductible expenses. The court analyzed cases involving prepayments and concluded that there was no support for widespread existence of a one-year rule.

The Tax Court further concluded that, even if a one-year rule existed, it would be inapplicable to an accrual-method taxpayer. Analyzing the cases involving prepayments, the court concluded that a one-year rule for accrual-method taxpayers was precluded. The court noted that the accrual method, unlike the cash method, attempts to match expenses with related income, finding that the use of the accrual method required the prepayments to be prorated over the period to which they related.

It appears that the Tax Court is incorrect in its interpretation of the one-year rule, for three reasons. First, a significant number of cases and Service pronouncements support the existence of a one-year rule. Second, a strict matching requirement for the accrual method is inconsistent with Sec. 461(h). Third, there does not appear to be support for the position that different capitalization criteria apply to cash- and accrual-method taxpayers.

Precedents Supporting One-Year Rule

The IRS invariably argues that the cases and rulings cited for the one-year rule involve expenditures that create a benefit that exceeds one year, and that the decisions and rulings do not infer that expenditures that create a benefit of one year or less are deductible expenses. The Service's interpretation is somewhat disingenuous when viewed against a backdrop of numerous IRS rulings that specifically conclude that expenditures are deductible expenses on the basis that the benefit created has a duration of less than one year; see Rev. Ruls. 78-382, 73-357, 69-560, 69-81, 68-134 and 59-249, which conclude that materials and supplies consumable within one year are deductible expenses. Moreover, the courts have specifically recognized that the one-year rule is a useful guidepost for distinguishing between capital expenditures and deductible expenses; see Jack's Cookie Company, 597 F2d 395 (4th Cir. 1979).

Strict Matching Is Inconsistent with Sec. 461(h)

The Tax Court appears to have attached a strict matching requirement to the accrual method, which appears inconsistent with Sec. 461(h).

Under the accrual method, liabilities are incurred in the tax year in which all the events have occurred that establish the fact of the liability, its amount can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability; see Sec. 461(h)(1) and Regs. Sec. 1.446-1(a)(2).

The all-events test (the first two requirements for treating a liability as incurred) for a liability that requires services to be provided to a taxpayer is satisfied on prepayment of the liability; see Regs. Sec. 1.461-1(a)(2) (application of the substantially beyond test to a prepaid liability assumes the liability is incurred), -4(d)(6)(ii) (application of 3 1/2-month rule assumes that a prepaid liability is incurred) and -4(g)(8), Example (6) (liability for five-year insurance policy incurred on prepayment).

The economic performance requirement for a liability that requires services to be provided to a taxpayer is generally satisfied as the services are provided; see Sec. 461(h)(2)(A)(i) and Regs. Sec. 1.461-4(d)(2). For a liability that arises out of the provision of insurance to a taxpayer, the economic performance requirement is satisfied on payment of the liability; see Regs. Sec. 1.461-4(g)(5). Similarly, for a liability to pay a governmental licensing fee or permit, the economic performance requirement is satisfied on payment of the liability; see Regs. Sec. 1.461-4(g)(6)(ii).

There are several examples in the Conference Report underlying the enactment of Sec. 461(h), which provide clear evidence that Congress did not intend strict matching and strongly suggest that it intended that prepayments of a liability creating a benefit with a duration of one year or less are not capital expenditures; see, e.g., H. Rep't No. 98-861, 98th Cong., 2d Sess. 875 (1984), which (in illustrating the operation of the recurring-item exception) provides that a calendar-year taxpayer that enters into a 12-month insurance contract on July 1 and prepays the premium may accrue the expense in its entirety in the payment year if the expense is immaterial.

In addition, the court's conclusion that accrual concepts required the prepayments of insurance and licensing fees to be prorated over the period to which they relate is inconsistent with Regs. Sec. 1.461-4(g)(5) and (6), which provide that such liabilities are deductible in the tax payment year.

A strict matching requirement is also inconsistent with the 3 1/2-month rule for services described in Regs. Sec. 1.461-4(d)(6)(ii). This permits taxpayers to deduct prepayments for services if they reasonably expect the services to be provided within 3 1/2 months after the payment date.

Finally, a strict matching requirement is inconsistent with the "recurring item" exception provided in Sec. 461(h)(3) and Regs. Sec. 1.461-5. The recurring-item exception permits taxpayers to deduct liabilities in the tax year the all-events test is satisfied if (1) economic performance with respect to the liability occurs before the earlier of the date the taxpayer files a timely return for the tax year or 8 1/2 months after the close of such tax year, (2) the item is recurring in nature and (3) the item is not a material item or the accrual of such item in the tax year in which the all-events test is met results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the tax year in which economic performance occurs. The matching requirement is deemed satisfied for liabilities described in Regs. Sec. 1.461-4(g)(6), including liabilities for insurance and licensing fees; see Regs. Sec. 1.461-5(b)(5)(ii). The court's insistence on strict matching for the t prepayments of insurance and licensing fees is inconsistent with the waiver of the matching requirement for these liabilities in the recurring item exception. Moreover, strict matching of prepayments for these liabilities produces the incongruous result of putting a taxpayer that defers his payment in a better position than a taxpayer that chooses to prepay them.

Different Capitalization Criteria for Cash and Accrual Taxpayers

Although the analysis in the opinion is less than clear, the Tax Court appears to have based its decision in USFreightways on its view of capitalization principles under INDOPCO, Inc., 503 US 79 (1992). The court apparently believes that there are different capitalization criteria for cash- and accrual-method taxpayers. However, it appears that the same capitalization criteria should apply to both cash- and accrual-method taxpayers. Sec. 461 requires a taxpayer to capitalize a liability under Sec. 263 or 263A if the liability results in the creation of an asset with a useful life extending substantially beyond the close of the tax year in which it was incurred. The regulations use the identical language to describe the capitalization requirement for the cash and accrual methods; see Regs. Sec. 1.461-1(a)(1) (cash method) and -1(a)(2) (accrual method).

Conclusion

The one-year rule serves as a guide in distinguishing between capital expenditures and deductible expenses, regardless of which accounting method a taxpayer uses. Therefore, the prepayments of insurance and licensing fees at issue in USFreightways were properly deductible in the tax payment year and the Tax Court erred in its opinion.

FROM RICHARD GODSHALK, J.D., ROBERT TESTOFF, J.D., AND JUDI BRUCE, CPA, WASHINGTON, DC