When is a liability a liability?

To deduct an accrued expense, an accrual-basis taxpayer must satisfy an all-events test. The test has two prongs: Does the liability exist and, if so, can it be measured with reasonable accuracy? Legally a liability exists when it is final, fixed and absolute; that is, when the last event creating it has occurred and economic performance has occurred.

During 1984 and 1985, Chrysler Corp. sold vehicles covered under a company warranty as well as by the Uniform Commercial Code and the Magnuson-Moss Act. On its 1984 and 1985 tax returns, Chrysler deducted the estimated amount of possible future warranty claims related to vehicles sold in those years. The IRS disallowed the deductions and assessed the company a deficiency Chrysler petitioned the Tax Court for relief, arguing that due to the warranty statutes the sale of the vehicles to its dealers was the last event that "fixed" its liability

Chrysler cited United States v. Hughes Properties, Inc., 473 US 593, where a casino accrued a deduction for future slot machine payouts when a state law required the casino to pay out a set percentage of the amounts put into the machines. The Supreme Court held that the last event that created the casino's liability was the placing of the last coin into the slot machines at the end of the year. Chrysler argued that in this case any statutory liability fixed the liability and thus satisfied the first prong of the all-events test.

The government cited United States v. General Dynamics Corp., 481 US 239, in which the Supreme Court disallowed a deduction for the estimated costs of employee medical expenses under a medical reimbursement plan. In that case the last event fixing General Dynamic's liability was when the employees filed proper claims with the company--not when the employees received medical care. Agreeing with the IRS, the Tax Court found that Chrysler's situation was similar to the General Dynamics case. The company appealed the case to the Sixth Circuit Court of Appeals.

Result. For the IRS. Both parties cited the same cases. The Sixth Circuit examined what a taxpayer must do in order to "establish liability with sufficient certainty" It held that although a statute imposing an obligation may be sufficient to establish an absolute liability, it is not necessarily sufficient. The court also held that Chrysler's warranty liability was contingent; to fix a liability a customer actually had to submit a warranty claim. Furthermore, a taxpayer may not deduct estimated expenses even though they are statistically certain.

This case illustrates the difference between the recognition of a liability and the related deduction for tax purposes on the one hand and the recognition of a liability and the related expense under generally accepted accounting principles (GAAP) on the other. GAAP requires only the existence of a present obligation resulting in the probable transfer of assets or the providing of services in the future as a result of a past transaction or event.

* Chrysler Corporation v. Commissioner, 436 F3d 644 (CA-6).

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.