C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y Tax Accounting BY JAMES E. SALLES parties, courts have consistently held that the discharge I n this month’s column: occurs when any conditions imposed under the agree- ment become met. An early case illustrates the point. In Walker v. Commissioner, 8 the taxpayer’s partnership 1. The Tax Court rules on the timing of income from dis- agreed with its creditors that its indebtedness would be charge of indebtedness in Lowry v. Commissioner 1 ; forgiven if it paid the original principal. The agreement 2. The Ninth Circuit, affirming the Tax Court in Bob Wondries Motors, Inc. v. Commissioner , 2 upholds was concluded in 1927 but the debt was not actually forgiven until 1930. The Fifth Circuit held, as had the the IRS’ conditions on automobile dealers’ use of a Board of Tax Appeals, that the 1927 agreement did not special method for reporting warranty income; provide for “present forgiveness” but was “an agree- 3. The Ninth Circuit also affirms the Tax Court in Suzy’s Zoo v. Commissioner , 3 holding that the taxpayer ment for forgiveness in the future, if and when the con- ditions were fulfilled.” Therefore, the income from dis- “produced” greeting cards and stationery and was charge of indebtedness was not reportable until 1930, therefore subject to the uniform capitalization (UNI- when the conditions were met and the actual cancella- CAP) rules; tion took place. 4. The Eighth Circuit affirms the Tax Court in In Shannon v. Commissioner , 9 the taxpayers and their MidAmerican Energy Co. v. Commissioner , 4 holding bank lender agreed that the taxpayers’ debt would be that the taxpayer did not become entitled to a forgiven once they paid the difference between the pro- “deduction” when regulators reduced rates ceeds of the sale of collateral and a fixed amount. The prospectively, and was required to report revenue agreement was executed and some of the collateral earned but unbilled at year-end; and was sold in 1986, but the bank did not receive the pro- 5. The IRS issues proposed regulations under Code ceeds and the additional payment until 1987. Had the Section 446 providing that the special timing rules for 1986 agreement been to forgive the indebtedness in transactions among members of a corporate consoli- exchange for the taxpayers’ promise to pay the reduced date group constitute a “method of accounting.” amount, the discharge of indebtedness income would have been realized in that year. However, because the agreement was conditional on the bank’s receiving pay- CONDITIONAL DISCHARGE OF ment, the Tax Court held that the taxable event did not INDEBTEDNESS occur until 1987. By contrast, Rivera v. Commissioner , 10 decided the Gross income includes income from the discharge of indebtedness, 5 except as otherwise provided in Code month after Shannon , involved a workout agreement con- cluded in 1987 that provided that the taxpayer’s debt Section 108. Discharge of indebtedness occurs in a vari- ety of factual settings, and the “identifiable event” 6 that trig- would be forgiven in exchange for a part payment upon execution and a further payment a few months later. The gers taxation is sometimes not so easy to identify. A recent final payment was not due until January 2, 1988, but the Tax Court memorandum case, Lowry v. Commissioner , 7 taxpayer actually paid during the last few days of 1987. reviews some of the applicable authorities. The court held that the discharge took place in 1987, When debt is discharged by agreement between the because once the taxpayer paid, “no contingency exist- ed as to the forgiveness of the indebtedness,” and the Jim Salles is a member of Caplin & Drysdale in Washington, D.C. remaining formalities were “ministerial.” 34 34 J A N U A R Y 2 0 0 2
C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y In Lowry , the taxpayer’s partnership agreed to convey the procedure required electing taxpayers to report a property to its mortgagor in exchange for a covenant full year’s share of income in the first year, while the cor- not to sue. The agreement was executed in 1993 but responding amortization deduction was calculated the partnership did not convey the property until 1994. based on the number of months that the insurance con- Citing Keith v. Commissioner , 9 the Tax Court stated that tract was in effect during the year. For example, if the real estate is considered transferred for tax purposes warranty were sold July 31, the dealer would have to when the “benefits and burdens” of ownership pass. report twelve months’ income in that year while only Since title to the property did not pass until 1994 and deducting five months’ expense. there was no evidence that the “benefits and burdens” The taxpayers in Wondries Motors elected to defer of ownership had shifted earlier, the forgiveness income under Revenue Procedure 92-98, but sought to became effective and the income was realized in 1994. cure the mismatch problem by taking a full year’s deduction regardless of the contract date. However, the NINTH CIRCUIT SUSTAINS Ninth Circuit agreed with the Tax Court in that electing REV. PROC. 92-98 taxpayers had to apply the procedure according to its terms. The court rejected the taxpayers’ attempt to rely The Ninth Circuit, affirming the Tax Court in Bob Wondries Motors, Inc. v. Commissioner , 12 held that tax- on the “matching principle” recognized in Johnson v. Commissioner, 17 which it distinguished on its facts. The payers electing the special method of reporting receipts court also refused to consider the taxpayers’ alternative from “service warranty contracts” under Revenue Procedure 92-98 13 had to calculate deductions as spec- argument that the receipts were not gross income in the first place, because they had failed to raise this argu- ified in that procedure, and could not use an alternate ment at trial. calculation that they contended more clearly reflected income. SUZY’S ZOO AFFIRMED Automobile dealers commonly maintain standing The IRS continued its winning streak in the Ninth arrangements with insurance companies under which Circuit with an affirmance in Suzy’s Zoo v. the insurers assume the dealers’ warranty liabilities in Commissioner , 18 a Tax Court case that held that a greet- exchange for a premium. The difference between what ing card company was a “producer” of property under the customer pays the dealer for the warranty and what the uniform capitalization (UNICAP) rules. Suzy’s Zoo the dealer pays the insurance company represents the designed greeting cards and stationery, but contracted dealer’s profit. Both payments are commonly lump sums paid at the beginning of the warranty term, typi- out the actual printing under contracts that left the print- cally several years. ers responsible for the paper stock and other physical components until the job was complete. Nonetheless, The IRS position in such cases is that the customers’ the Tax Court held that Suzy’s Zoo was the “producer” payments are income to the dealer because it is the deal- of the property, not merely a reseller, because the print- er that contracts to provide the warranty protection, even ers were contract manufacturers and never had any if the insurer immediately assumes the risk. That charac- right to the finished product. terization requires dealers to report the customers’ pay- ment as income in the year of receipt under the The Ninth Circuit agreed with the Tax Court that Suzy’s “ Schlude 14 doctrine,” which requires accrual taxpayers to Zoo produced the greeting cards and stationery. In report most advance payments as income in the year that general, contract manufacturers’ activities are attributa- ble to their customer, 19 and the regulations’ exception for they are received, even if performance occurs in a later “routine purchase order[s] for fungible property” 20 did year. 15 The dealer can deduct its payments to the insurer, but only over the lifetime of the contract. 16 not apply. The regulations provide that the “producer” is “the owner of the property produced ,” 21 and that was Revenue Procedure 92-98 attempted to deal with the resulting mismatch between income and deductions by Suzy’s Zoo; the printers never had any right to the print- giving taxpayers an election to report the warranty ed goods. Therefore, Suzy’s Zoo was ineligible for the income over time, in exchange for reporting some extra various exceptions provided for resellers of property 22 “phantom” interest on the deferred amount. However, and had to capitalize its production costs. The appellate J A N U A R Y 2 0 0 2 35
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