The Tax Court sided with the IRS in the case of The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142.[1] The Court found the taxpayers could not claim a tax deduction for certain accrued expenses, finding that not all events had taken place to establish the fact of the liabilities in question.

A taxpayer reporting on the overall accrual method of accounting must generally demonstrate two items in order to be able to claim a deduction on the current year’s return.

Economic performance with regard to the item in question[2] and
All events have occurred that determine the fact of a liability and the amount of that liability can be determined with reasonable accuracy.[3]

The taxpayer in question provided bulk-packaged tomato products to food processors and customer-branded finished products to the food service and retail trades. The Court noted that the taxpayers “account for about 25% of the California processing tomato production, supplying 40% of the United States ingredient tomato paste and diced tomato markets.”[4]

The taxpayer’s facilities operated 24 hours a day from July to October during the period when tomatoes are harvested. The taxpayers are subject to strict rules regarding cleanliness and food safety, with issues that may arise shutting down the entire processing line. If that condition persists for any significant period of time, the taxpayers would face large losses due to spoilage, having to pay farmers for tomatoes they were not able to actually use to create products and being liable to customers who now face a lack of product necessary for their operations.[5]

Because of these risks, the taxpayers have specific covenants in their loan agreements that require the organization to maintain all necessary licenses and keep their equipment in good working order. A failure to meet these objectives would be an event of default under the credit agreements.[6]

The Tax Court discusses the expenses in dispute as follows:

The costs in issue are costs to restore, rebuild, and retest the manufacturing facilities for use during the next production cycle. The accrued production costs include amounts to be paid for goods and services. The partnerships maintain reserves that they refer to as “production accrual” (production accrual reserve accounts). These reserves are used to account for future costs associated with restoring, rebuilding, and retesting the manufacturing facilities for use during the next production cycle. The production accrual reserve accounts for both TMSPC and LPC included: amounts for production labor, boiler fuel, electricity, waste disposal, chemicals and lubrication, production supplies, repairs and maintenance, lease, production wages, and administration wages.

The accrued production costs were recurring, and the partnerships determined the amounts to be set aside in the reserves to cover these costs with reasonable accuracy. The partnerships issue payroll checks every other Thursday for work performed for the two-week period ending the Saturday before payday. Thus, payroll was paid between 5 and 19 days after the services were performed. The partnerships generally paid accounts payable 30 days after the goods and services were provided. For many reasons, including the sterility of the facilities when they are in operation, it is most efficient to delay some of the restoring, rebuilding, and retesting work until closer to the beginning of the next production cycle. Except for a de minimis amount of goods and services provided and paid for by December 31, the goods and services are not provided or paid for until the next year. Hence, economic performance of the production accrual liabilities does not occur until the next taxable year.[7]

The IRS argued that these accrued costs could not be included in the current year’s cost of sales. The Court notes:

In two FPAAs for years 2008 and 2009 and years 2010 and 2011 for each partnership, the Internal Revenue Service (IRS) determined that neither was entitled to increase its COGS for the amount of accrued production costs because: (1) the partnership had not shown that all events had occurred to establish the fact of the liabilities and (2) economic performance had not occurred with respect to the liabilities to qualify for accrual for the years claimed. The IRS concluded that if the partnerships’ financial accounting years ended on December 31 instead of June 30, their December 31 yearend financial statements would not comply with GAAP because the accrued production costs were included in COGS.[8]

The IRS specifically argued:

Respondent has conceded that the partnerships determined the accrued production costs with reasonable accuracy and that they complied with the economic performance requirement. However, respondent contends that the accrued production costs consisted of bilateral contracts for goods and services to recondition the partnerships’ manufacturing facilities that were provided to and paid for by the partnerships after the December 31 close of their tax year. Respondent argues that all events had not occurred during the years in issue to establish the fact of the liabilities for the accrued production costs.[9]

The taxpayer countered with the following argument:

The partnerships contend that respondent’s focus on the bilateral goods and services contracts is misplaced. Instead the partnerships argue that their credit agreements and multiyear contracts to supply customers with tomato products obligated them to incur the accrued production costs to restore, rebuild, and retest the manufacturing facilities.[10]

The Tax Court agreed with the IRS’s view and did not accept that the credit agreement covenants created a liability at the end of the tax year

The credit agreements involved in these cases do not specifically set forth the partnerships’ obligations to provide a comparably sufficiently fixed and definite basis. Instead the credit agreements include nonspecific text and generalized obligations. The agreements merely require that the partnerships “maintain all material licenses, Permits, [and] governmental approvals”, comply with “all laws”, and “keep all property useful and necessary in its business in good working order and condition”. The credit agreements neither specify which laws or regulations must be complied with nor identify exactly which property must be kept in good working order. Accordingly, we conclude that the generalized obligations found in the credit agreements do not establish the fact of the partnerships’ liabilities for the accrued production costs for the years in issue.[11]

The Court also rejected the argument that multi-year contracts with some customers created the liability as well:

The partnerships alternatively assert that their multiyear production contracts with various customers establish the fact of their liabilities for the accrued production costs. While these production contracts involve extensive product quality specifications, the partnerships’ efforts to comply with their customers’ specifications are production-run specific. Such compliance necessarily takes place before and during the production run of tomato products for a given customer. The accrued production costs in issue were for goods and services provided after the production run in each year in issue. Furthermore, the parties have stipulated that the accrued production costs in issue are to restore, rebuild, and retest the manufacturing facilities for use during the next production cycle. We conclude that the partnerships’ multiyear production contracts fail to establish the fact of the liabilities for the accrued production costs for the years in issue.[12]

[1] The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142, October 14, 2020, https://www.ustaxcourt.gov/UstcInOp2/OpinionViewer.aspx?ID=12343 (retrieved October 14, 2020)

[2] IRC §461(h)(2) taking in account the special recurring item rule found at IRC §461(h)(3)

[3] IRC §461(h)(4)

[4] The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142, p.4

[5] The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142, pp. 5-6

[6] The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142, pp. 8-10

[7] The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142, pp. 10-11

[8] The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142, pp. 12-13

[9] The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142, p. 15

[10] The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142, pp. 15-16

[11] The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142, p. 17

[12] The Morning Star Packing Company, L.P. et al v. Commissioner, TC Memo 2020-142, pp. 17-18