Seventh Circuit Takes a Pragmatic Approach on Accrual of Recurring Expenses

In late 2001, the Seventh Circuit reversed the Tax Court in U.S. Freightways Corp., 270 F3d 1137 (2001). The taxpayer's long-haul freight trucking business incurred significant expenditures for 12-month permits, licenses and insurance premiums associated with its fleet. The taxpayer deducted these items as incurred, but the IRS argued (and the Tax Court agreed) for capitalization and amortization over the related 12-month periods.

On appeal, the Seventh Circuit held that the court had determined improperly that the accrual method did not allow the taxpayer to deduct the expenses under a "one-year" rule. The appellate court determined that the criteria for capitalization or expensing a particular item should not turn on the taxpayer's using the cash or the accrual method, and that the taxpayer's activity with these expenditures and their future economic benefits should control. The Seventh Circuit also recognized that the timing of the deductions had nothing to do with tax planning and manipulating the economics, but reflected true business need.

U.S. Freightways had to purchase a large number of permits and pay significant fees and insurance premiums to legally operate its trucks. The licenses, permits and fees were valid for no more than 12 months. The Seventh Circuit took a common-sense approach, looking specifically at the regulations under Sec. 263 to understand the concept of capitalization when the expenditure extends "substantially beyond" the tax year.

The court recognized that, although there has never been a clear understanding of what "substantially" means, the use of a 12-month criteria may (under the right circumstances) produce a proper approach. This is true in cases such as U.S. Freightways', which has no real control over the renewal process for critical licenses and insurance coverage. Therefore, the appropriate analysis is that such recurring items have no benefit beyond the 12-month period, and therefore do not have "substantial" longevity. Rejection of a "one-year rule" (that may have been used in dealing with cash-basis taxpayers) simply because a taxpayer is on the accrual method is unfounded. Said another way, the Seventh Circuit noted that such expenses are not suitable for amortization, given U.S. Freightways' facts.

The decision to expense or capitalize a particular item may not turn on whether a taxpayer uses the cash or accrual method. The critical analysis is whether the item demonstrates benefit "substantially beyond the tax year" of the expenditure. In many cases, this is subjective or difficult to quantify. In such cases, the Seventh Circuit implied that a practical business approach should be relevant, particularly when the expense can never relate to more than a 12-month period. The court illustrated the point with a light bulb that was expected to last for only eight months, but turned out to be burning brightly after 14 months. They questioned the effective use of the time and effort it would take to capitalize office supplies and pens (some disposable), which may function into a new year.

Despite the Seventh Circuit's decision, taxpayers need to take care when planning whether to capitalize or expense items. The court made it very clear that it would look less favorably on tax-planning manipulations to achieve a particular result. In addition, the case was remanded to the Tax Court to consider an issue not addressed in its initial opinion. Due to its emphasis on the one-year rule for an accrual-basis taxpayer, the Tax Court failed to look specifically at another IRS argument that the accounting method did not clearly reflect the income.

Because the IRS has discretion in evaluating whether an accounting method clearly reflects income, practitioners should monitor the Tax Court's review of this issue. Nevertheless, courts are willing to respect the nature of a transaction and its practical benefit to businesses. The Seventh Circuit agreed that U.S. Freightways' accounting method was basically sound. It noted that perfection in the matching of revenue and expenses may come at too high a price and that the administrative cost of achieving a more perfect match becomes too great.

From Christopher C. Adler, CPA, Baltimore, MD