Ninth Circuit affirms failure to satisfy all-events test

The Ninth Circuit Court of Appeals has affirmed a Tax Court decision in favor of the IRS, finding that a taxpayer’s anticipated reconditioning expenses could not be deducted because the expenses failed to satisfy the all-events test. The decision provides insight into a highly factual analysis that can hinge on the contractual language in financing agreements requirements for maintaining equipment.

In Morning Star v. Commissioner (Docket 21-71191, 21-71192, 21-71193), the Ninth Circuit analyzed the taxpayer’s financing agreements and customer contracts, concluding that the agreements did not create an obligation that fixed the liability for the taxpayer to recondition its facilities.

Section 461 and the regulations thereunder generally provide that a liability is incurred under the accrual method of accounting in the taxable year in which:

• All events have occurred that establish the fact of the liability and the amount of the liability can be determinable with reasonable accuracy (the all-events test)
• Economic performance has occurred with respect to the liability.

A fundamental component of establishing if the all-events test has been met is identifying the event that fixes the liability.

The taxpayer in Morning Star is a tomato paste producer that operates its tomato processing equipment 24 hours a day over the course of a 100-day harvest season. Shortly before the beginning of the next year’s harvest season, the taxpayer reconditions its equipment. The taxpayer’s reconditioning costs are substantial and, on an annual basis, the amount can be up to $21 million. Terms and conditions provided in certain of the taxpayer’s financing agreements require the taxpayer to keep its business property in “good condition and repair,” “good operating order and repair,” and “good working order and condition,” but notably except reasonable, normal, and ordinary wear and tear.

The taxpayer asserted that the final production run of the harvest season fixes its liability to recondition its facilities because, under its financing agreements, an obligation to recondition its facilities could be inferred. Citing the substantial costs to recondition its facilities, the taxpayer alleged that its reconditioning costs were not excepted under the ordinary wear and tear provisions of its financing agreements because, after a harvest season, its facilities were “in a state of disrepair.” Further, the taxpayer argued that production requirements established under its customer contracts result in “a high degree of certainty that the reconditioning costs would in fact be completed,” thus fixing its reconditioning liability.

The Ninth Circuit applied contract law principles to evaluate the terms of the financing agreement, finding that the taxpayer’s reconditioning activities are within the plain meaning of “wear and tear,” which is excepted from the financing agreement obligations. Further, the Ninth Circuit countered the taxpayer’s claim that its substantial reconditioning costs indicated a state of disrepair, stating that, because the taxpayer could process another shipment right after its last production run, reconditioning is necessary to prepare for the next production cycle rather than to repair inoperative equipment. Addressing the taxpayer’s customer contracts, the Ninth Circuit concluded that establishing a high likelihood of reconditioning the equipment is not the same as an obligation.

One judge dissented, citing United States v. Hughes Properties, Inc., 476 U.S. 593 (1986) and Gold Coast Hotel & Casino v. United States, 158 F.3d 484 (9th Cir. 1998), to argue that the taxpayer’s liability was fixed at the end of each harvest season’s production run because, without restoring, rebuilding and sterilizing the equipment, the taxpayer could not use its equipment and would default on its various agreements. The judge stated that the last production run was directly analogous to the last play in Hughes or the accumulation of 1,200 points in Gold Coast. In contrast to the majority opinion, the dissent argued that $21 million was too high of a cost to be ordinary wear and tear and that the taxpayer’s reconditioning was more analogous to catastrophic damage. 

Contacts: