The Ninth Circuit Court of Appeals, in a split decision, upheld[^1] the Tax Court’s holding in the case of The Morning Star Packing Co. LP et al. v. Commissioner, TC Memo 2020-142 that the all events test had not been met by a taxpayer with respect to costs to restore, rebuild, recondition, and retest their manufacturing facilities recorded at the end of the taxpayers’ tomato products packaging season.

Production Process

The Tax Court[^2] describes the Morning Star Packing Company’s (Morning Star) tomato processing as a high-volume operation that occurs during a 100-day harvest season. Here’s a breakdown of their process:

Tomato Acquisition: Morning Star purchases tomato seeds in December, and typically has oral agreements with farmers for tomato purchases, with written agreements to follow.
Harvest and Delivery: In June and July, farmers harvest tomatoes and deliver them to Morning Star’s facilities. Freshly harvested tomatoes have a short shelf life and must be processed quickly.
Facility Operations: The company’s three facilities operate 24 hours a day during the harvest season, from approximately July to October.
Processing:
- Tomatoes move from trucks through a tomato flume to sorting tables, choppers, and hot break tanks.
- The product is then in a closed, sterile environment, and if there are any air leaks, the sterility is lost, requiring a shutdown.
- Powerful pumps propel the product through holding tanks, finishers, multistage evaporators, and a FranRica flash cooler.
- Finally, the product is packaged in sterile containers for shipment.
Sterility: Sterility is extremely important to the process. The facilities are designed so that if any part of the processing line fails, the entire facility ceases production, due to a loss of sterility. Morning Star’s facilities are single-line plants with no redundancy.
Heat: Heat, provided by large natural gas boilers, is a crucial element in the evaporation process. The boilers are subject to stringent emission rules and regulations.
Customer Requirements: Customers require that the tomato products meet certain quality and sanitary specifications, and many require independent testing for assurance. The facilities must pass inspections by the USDA, the U.S. Food and Drug Administration, and the State of California Department of Public Health.
Product Output: Morning Star supplies 40% of the United States ingredient tomato paste and diced tomato markets, accounting for about 25% of California’s processing tomato production.

After the 100-day season, Morning Star’s equipment requires extensive reconditioning. The company typically services the equipment before the next year’s season. The cost to restore, rebuild, and retest the facilities can be between $16.7 million and $21 million.

The All Events Test

IRC §446(h)(4) provides the “all events” that must be met by an accrual taxpayer in order to recognize an expense. It states “[f]or purposes of this subsection, the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.”

The “all events” test determines when a liability is incurred and can be recognized for tax purposes. According to the Tax Court and Ninth Circuit’s opinions[^3], the test has three prongs, all of which must be met for a liability to be considered incurred:

The fact of liability must be established: This means that all events must have occurred to determine that a liability exists. According to the Ninth Circuit, this liability must be “fixed, absolute, and unconditional”. The Tax Court also notes that a liability may not be deducted if it is contingent upon a future event. The fact of a liability is established on the earlier of the event fixing the liability or the date the payment is unconditionally due.
- The Ninth Circuit cites Gold Coast, 158 F.3d at 487, and Challenge Publ’ns, 845 F.2d at 1544 to support their interpretation of this requirement.
- The Tax Court cites Brown v. Helvering, 291 U.S. 193, 201 (1934), Lucas v. N. Tex. Lumber Co., 281 U.S. 11, 13 (1930), and Lucas v. Am. Code Co., 280 U.S. 445, 452 (1930) to support their interpretation of this requirement. The Tax Court also cites VECO Corp. & Subs. v. Commissioner, 141 T.C. 440, 461 (2013).
The amount of the liability must be determined with reasonable accuracy.
- This specific aspect of the test is not disputed in this case.
Economic performance must have occurred.
- The Tax Court notes that the IRS conceded that this requirement had been met by Morning Star.

The Ninth Circuit notes that the timing of the moment in which a liability is fixed is essential. Additionally, a taxpayer may not deduct an estimate of an anticipated expense, no matter how statistically certain, if it is based on events that have not occurred by the close of the taxable year. The dissenting opinion in the Ninth Circuit case also emphasizes that the law does not require the taxpayer to prove the fixed obligation to a “metaphysical certitude”.[^4]

The Tax Court explains that “liability” refers to “any item allowable as a deduction, cost, or expense for Federal income tax purposes”. The court states that the production costs reflected in Morning Star’s cost of goods sold come within this definition. The court also notes that the all events test governs whether a business expense has been incurred to permit its accrual for tax purposes, citing Challenge Publ'ns, Inc. v. Commissioner, T.C. Memo. 1986-36, 1986 Tax Ct. Memo LEXIS 570, at 22, aff'd, 845 F.2d 1541 (9th Cir. 1988).[^5]

Morning Star’s Reasoning Regarding Why the Fact of the Liability Test Had Been Met

According to the Tax Court, Morning Star argued that its end-of-season reconditioning expenses met the “fact of liability” prong of the “all events” test based on two main points:

Credit Agreements: Morning Star contended that its credit agreements obligated it to incur the reconditioning costs. The company argued that these agreements required it to maintain its equipment in “good working order and condition”. According to Morning Star, this obligation necessitated the reconditioning of its facilities at the end of each production season.
- The agreements state that Morning Star must maintain its equipment in “good condition and repair,” and “good operating order and repair,” while making exceptions for ordinary wear and tear.
Multiyear Production Contracts: The company also asserted that its multiyear contracts to supply customers with tomato products created an obligation to restore, rebuild, and retest the manufacturing facilities. Morning Star argued that to fulfill these contracts, it was necessary to incur the reconditioning costs.
- Morning Star’s customer contracts contain extensive product quality specifications.

Morning Star’s position was that these agreements created a fixed liability for reconditioning expenses that should be recognized in the year the expenses were incurred, rather than when the work was actually performed. They argued that the need for this work was a consequence of their production run, and therefore the liability was fixed at the end of the season. The company also claimed that its contracts with customers provided a “high degree of certainty” that reconditioning costs would be completed.

However, the Tax Court disagreed, concluding that the generalized obligations in the credit agreements did not establish a fixed liability for the accrued production costs. The court also determined that the customer contracts did not create a fixed liability for these specific expenses, as the contracts were production-run specific. Instead, the court viewed the reconditioning as preparation for the next production cycle, rather than a repair of inoperable equipment.[^6]

Ninth Circuit’s Majority Opinion Analysis

The Ninth Circuit's majority upheld the Tax Court's decision, concluding that Morning Star's anticipated expenses for reconditioning its facilities did not meet the "fact of liability" prong of the "all events" test. Here’s a breakdown of their reasoning:

Financing Agreements: The court found that Morning Star’s financing agreements did not explicitly require the company to recondition its equipment. While the agreements did stipulate that Morning Star must keep its property in “good condition and repair,” “good operating order and repair,” and “good working order and condition,” these terms were qualified by exceptions for “reasonable wear and tear,” “normal wear and tear,” and “ordinary wear and tear”.
- The court defined “wear and tear” as “[d]eterioration caused by ordinary use”. Since Morning Star did not dispute that its equipment's deterioration was a result of ordinary use in processing tomatoes, the court concluded that the financing agreements did not obligate the company to recondition its equipment under the plain meaning of the wear and tear exceptions.
- The court reasoned that if lenders needed to repossess the equipment, they likely would not care whether it had been reconditioned, since it would need to be sterilized again anyway.
- Additionally, the court noted that if Morning Star’s interpretation of the agreements were correct, they would be in breach of contract for most of the year while waiting to recondition the equipment right before the next production cycle, which is not the case.
Reconditioning vs. Repair: The court determined that the reconditioning was necessary to prepare for the next production cycle, not to repair inoperative equipment.
- The court observed that if a truck of tomatoes arrived immediately after the last production run, the facilities could process them without reconditioning. This fact further supported the conclusion that the reconditioning was not a necessary repair of the equipment, but rather preparation for the next season.
Customer Contracts: The court found that Morning Star’s contracts with customers did not create a fixed liability for reconditioning costs, as those contracts did not directly require reconditioning expenses. Although Morning Star argued its commitments to customers made it highly likely that the reconditioning would be done, the court explained that a high likelihood is not equivalent to a certain obligation. The court characterized Morning Star’s argument as “a mere estimate of liability” based on predicted future tomato sales, which is not sufficient to meet the “fact of liability” prong of the “all events” test.
“All Events” Test: The court explained that to meet the “fact of liability” prong of the all-events test, the liability must be “fixed, absolute, and unconditional”. The court determined that Morning Star’s obligations did not meet this standard.
Contract Law Principles: The court stated that it looked to contract law principles and the plain meaning of contract terms to determine Morning Star’s obligations. The court noted that under both New York and California law, courts interpret contract provisions in accordance with their plain meaning.

In summary, the Ninth Circuit’s majority found that neither the financing agreements nor the customer contracts created a fixed, absolute, and unconditional liability for reconditioning expenses at the end of the production season. Instead, the court viewed the reconditioning as a discretionary expense incurred to prepare for the next production cycle, not a legally required obligation from the previous season.

As such, the Court ultimately sustained the Tax Court’s finding that these expenses could not be included in cost of good sold for the just concluded production season and accrued immediately at the end of that season.[^7]

Dissent Finds the Expenditures Were Clearly More Than Just Ordinary Wear and Tear

The dissenting judge in the Ninth Circuit case disagreed with the majority's conclusion, arguing that Morning Star’s reconditioning expenses did meet the “fact of liability” prong of the “all events” test. The dissent’s objections to the majority's reasoning can be summarized as follows:

Misinterpretation of “Wear and Tear”: The dissent argued that the majority misinterpreted the “wear and tear” exception in the financing agreements. The dissent asserted that the $16.7 to $21 million in reconditioning costs necessary to restore the facilities to their pre-production operating capacity could not be considered “ordinary wear and tear”.
- The dissent argued that “ordinary wear and tear” refers to minor issues such as faded tiles or a loose door handle, not “catastrophic damage that requires millions to repair”.
- The dissent found it unreasonable to consider a recurring $21 million expense as “ordinary wear and tear”.
Fixed Liability: The dissent argued that Morning Star’s liability was fixed at the end of each production season due to a combination of factors:
- Loan Agreements: The dissent noted that loan agreements required Morning Star to maintain its equipment in “good condition and repair” and prevent negligence in its care and use.
- Credit Agreements: Additionally, credit agreements directed Morning Star to “keep all property useful and necessary in its business in good working order and condition” and prevented the company from defaulting on other contracts, including the loan agreements.
- Customer Agreements: The dissent also argued that Morning Star's multiyear contracts to supply customers mandated that the company recondition its equipment at the end of the tomato processing season.
- Necessity of Reconditioning: According to the dissent, without reconditioning, Morning Star could not reuse its equipment, which would place them in default of their various agreements and would be unable to fulfill its tomato processing obligations. The dissent highlighted that lenders would not loan significant amounts of money if Morning Star could damage the collateral without a duty to repair.
- The dissent drew an analogy between the end of the production run and the “last play” in Hughes Properties or the accumulation of points in Gold Coast, where a liability becomes fixed.
Analogy to Previous Cases: The dissent cited United States v. Hughes Properties, Inc. and Gold Coast Hotel to support its position. The dissent argued that, similar to the casino in Hughes Properties being liable for the progressive slot machine jackpot and the casino in Gold Coast Hotel being liable for the redeemable points, Morning Star’s liability for reconditioning was fixed at the end of each season.
- The dissent stated that these cases establish the principle that when liability is legally certain, the taxpayer may deduct it in the tax year in which it became fixed and that the law doesn’t require metaphysical certitude.
IRS View of Taxpayers' Money: The dissent also criticized the IRS’s view, which the dissent characterized as treating any disagreement on when a tax payment is due as an “interest-free loan from the government”. The dissent stressed that taxpayers’ income is not government property and that the IRS should not have the presumption that money is theirs when there is a good-faith disagreement on tax laws.

In summary, the dissent believed that the majority incorrectly interpreted the “wear and tear” exception and failed to recognize that Morning Star's various contractual obligations, combined with the practical necessity of reconditioning its equipment, created a fixed liability at the end of each production season. The dissent argued that the need to recondition the equipment was a direct result of the production run, thereby meeting the requirements of the “all events” test.

Nevertheless, unless the taxpayer either asks for and receives an en banc rehearing of their case before the Ninth Circuit or asks and convinces the U.S. Supreme Court to hear an appeal of this decision, the majority opinion controls in this case and the taxpayer must defer accruing these expenses.

[^1]: The Morning Star Packing Co. LP et al. v. Commissioner, TC Memo 2020-142, aff’d CA9, Dockets No. 21-71191; No. 21-71192; No. 21-71193; No. 21-71194, December 19, 2024, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/ninth-circuit-affirms-denial-anticipated-expense-deductions/7pgth

[^2]: The Morning Star Packing Co. LP et al. v. Commissioner, TC Memo 2020-142, October 14, 2020, https://scholar.google.com/scholar_case?case=17053115870350666974&q=TC+Memo+2020-142&hl=en&as_sdt=806

[^3]: The Morning Star Packing Co. LP et al. v. Commissioner, TC Memo 2020-142, aff’d CA9, Dockets No. 21-71191; No. 21-71192; No. 21-71193; No. 21-71194, December 19, 2024, The Morning Star Packing Co. LP et al. v. Commissioner, TC Memo 2020-142, October 14, 2020

[^4]: The Morning Star Packing Co. LP et al. v. Commissioner, TC Memo 2020-142, aff’d CA9, Dockets No. 21-71191; No. 21-71192; No. 21-71193; No. 21-71194, December 19, 2024

[^5]: The Morning Star Packing Co. LP et al. v. Commissioner, TC Memo 2020-142, October 14, 2020

[^6]: The Morning Star Packing Co. LP et al. v. Commissioner, TC Memo 2020-142, October 14, 2020

[^7]: The Morning Star Packing Co. LP et al. v. Commissioner, TC Memo 2020-142, aff’d CA9, Dockets No. 21-71191; No. 21-71192; No. 21-71193; No. 21-71194, December 19, 2024