C C C O O O R R R P P P O O O R R R A T A T A T E E E B B B U U U S S S I N I N I N E E E S S S S S S T T T A A A X X X A T A T A T I O I O I O N N N M M M O O O N N N T T T H H H L Y L Y L Y Tax Accounting BY JAMES E. SALLES Arthur Murray dance studio. Schulde is generally read to “CLEAR REFLECTION” PRINCIPLES require accrual-basis taxpayers to report income in three MAY WORK FOR TAXPAYERS TOO situations: he Eighth Circuit has partially reversed the T ax T 1. When cash or other property is received; Court’s decision in Johnson v. Comm’r . 1 The 2. When the taxpayer becomes entitled to immediate decision addressed a variety of issues concern- payment; or ing automobile dealers’ treatment of advance payments 3. As performance occurs under the contract, whichever under vehicle service contracts (VSCs), which are sold occurs first, e.g., Revenue Ruling 74-607, 1974-2 C.B. along with new automobiles. 149. The Johnson Facts Economic Benefit The automobile dealers sold VSCs along with both new Comm’r v. Hansen , 360 U.S. 446 (1959), involved so- and used motor vehicles. VSCs were similar to insurance called dealer reserves withheld from automobile dealers policies: In return for payment in advance, the dealer when they factored sales receivables. The T ax Court and contracted to make any necessary repairs to the vehicle the Eighth Circuit in Johnson held, in keeping with a line (over and above a deductible) for the contract term, or to of cases beginning with Hansen , that the amounts were pay third parties to make any of these repairs. in effect “received” by the dealer. Here the amounts in The dealers kept part of the sales price of the VSCs, escrow were fated ultimately either to be released to the which they reported as current income. The remaining dealer or applied to the obligations the dealer assumed amounts, which were placed in escrow, had three under the VSC, so that either way the escrow amounts objectives: could be used to the dealer’s benefit. 1. T o secure the dealers’ obligations to perform under the This Johnson decision is consistent with the broader contracts; doctrine of “economic benefit.” Even a cash-basis tax- 2. T o pay sales commissions and the administrators’ fees; payer that possesses vested rights to the ultimate receipt and of an amount held or secured by a trust or other segre- 3. T o buy excess loss insurance through an unrelated gated fund is taxable as in receipt of “property.” The eco- insurer (T ravelers). nomic benefit rule applies even though the taxpayer may The controversy concerned the proper time for reporting not be able to realize those rights immediately. E.g., the portion of the receipts placed in escrow and the prop- Sproull v. Commissioner, 16 T .C. 244 (1951), aff’d .,194 er time for the deduction of the associated expenses. F .2d 541 (6th Cir. 1952), and Pulsifer v. Commissioner, 64 T .C. 245 (1975). Similarly, the Johnson court treated the Reporting of Income establishment of an income amount as a receipt under The parties disputed numerous issues relating to the Schlude . “income side,” but the courts’ holdings broke no new ground. The Supreme Court’s decision in Schlude v. Inclusion of Income Comm’r , 372 U.S. 128 (1963), required current reporting The Schlude rule assumes that the receipt is in fact of advance payments for dance lessons received by an income to the taxpayer in the first place. The taxpayers disputed this result on two grounds: 1. The T ax Court rejected the dealers’ argument that their James E. Salles is a member of Caplin & Drysdale, Chartered, in receipt of cash, subject to an obligation to turn the cash Washington, DC. N O V E M B E R 1 9 9 9 1
C C C C O O O O R R R R P P P P O O O O R R R R A T A T A T A T E E E E B B B B U U U U S S S S I N I N I N I N E E E E S S S S S S S S T T T T A A A A X X X X A T A T A T A T I O I O I O I O N N N N M M M M O O O O N N N N T T T T H H H H L Y L Y L Y L Y over to the escrow agent, was a receipt in the capacity Timing of Deductions of agent or fiduciary for their customers, and thus not It is the courts’ much shorter discussions of the issues taxable to them. The court analyzed the documents and concerning when the dealers became entitled to deduc- concluded that the escrow agents’ duties ran to the tions that present the most food for thought. Accrual- dealers, not to the customers. If a customer canceled a basis taxpayers generally are entitled to take expendi- VSC, it was the dealer, not the escrow agent, who tures into account, for tax purposes, when the taxpayer became liable to make a pro rata refund. See 108 T .C. meets the “all-events” test and “economic performance” at 466. Any release of escrowed funds for that purpose is assured. This all-events test is met when all events was in fact a payment for benefit of the dealer. have occurred that determine both the fact of liability 2. A deposit is not income even if received up front in and the amount of such liability with reasonable accura- cash with no strings attached. Commissioner v. cy. 3 “Economic performance” means the goods or Indianapolis Power & Light Co., 493 U.S. 203 (1990). A services for which payment is being made. An expendi- merchant is ordinarily obliged to return a deposit unim- ture is “taken into account” through capitalization rather paired unless the deposit is later applied to the cus- than a deduction if the expenditure produces an asset tomer’s account because of a default. The obligation to “having a useful life extending substantially beyond the pay the customer back is a sufficient “string” to prevent close of the taxable year.” 4 taxation, in the same way that the receipt of a loan does The IRS and both courts agreed that the insurance not produce income to the borrower. However, the premiums were capital expenditures and should be touchstone of a deposit is precisely the fact that the amortized over the policies’ term. As to the administra- amount remains a credit in favor of the customer until, tion fees, the IRS argued that these fees should be cap- because of some subsequent event (e.g., the cus- italized and written off only as each VSC expires. The tomer’s direction or a default), the default is applied as a T ax Court agreed that the administration fees should be payment. capitalized, but allowed an amortization over the term of the VSC based on the refund schedule that applied Advance Payments between the automobile dealer and its customer. For A receipt that is designated from the outset as to be example, at the point at which the dealer would only be applied to the future purchase of goods or services is required to refund 50 percent of the customer’s original not a deposit, but an advance payment. As is common payment in the event of cancellation, it could take a in advance-payment situations, the dealers’ customers deduction for 50 percent of the administration fees relat- would be entitled to a pro rata refund if they cancelled ing to that contract. The Eighth Circuit, however, reject- the VSCs, but the T ax Court rejected the dealers’ argu- ed both approaches, and allowed an immediate deduc- ments that process would somehow convert the tion. Its reasoning was based on broad grounds: advance payments into deposits until the amounts became nonrefundable. If taxpayers are going to be required to take into The dealers had a receipt of an advance payment that income the entire amount paid into the escrow fund was presumed to be taxable under Schlude . in the year of receipt and payment, we think, as a Administrative exceptions apply to the Schlude doc- matter of fairness, that they should also be allowed trine, but these transactions do not apply to warranty to deduct, in that year, the entire amount of the fee contracts like VSCs. 2 Some courts have recognized a paid to the Administrator. . . . narrowly drawn exception that applies if there is certain- The Commissioner argues that economic performance ty of performance on a particular date or dates (e.g., has not yet occurred with respect to the liability. . . . While Artnell Co. v. Commissioner, 400 F .2d 981 (7th Cir. this is certainly true in the abstract, the question in this 1968)), but such circumstances clearly did not exist in case is whether the method of accounting proposed by Johnson . 108 T .C. at 491-93. Thus, the dealers had to the Commissioner clearly reflects income. T o answer report the up-front payments for the VSCs in full. The that question both income and deductions must be con- court held that the income earned on the escrowed amounts was taxable to the dealers under the grantor sidered. If the income is to be recognized, and we have trust provisions. upheld the Commissioner’s decision on that point, the 2 N O V E M B E R 1 9 9 9
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