Failure to Satisfy All-Events Test Denies S Corp. Deductions

In Jimmy D. Weaver, 121 TC No. 14 (2003), the Tax Court held that S corporation shareholders could not deduct expenses the S corporation incurred in the years claimed, because it failed to satisfy the economic performance prong of the Sec. 461(h) all-events test.

Facts

James D. Weaver owned an 80% interest in Clarkston Window & Door, Inc. (Clarkston), an accrual-method S corporation that sold construction materials at wholesale. He also owned an 80% interest in J.D. Weaver & Associates, Inc. (J.D.), a cash-method C corporation that installed windows. Clarkston is a calendar-year taxpayer, while J.D. operates on a fiscal year with a July 31 year-end.

On its 1996 return, Clarkston deducted $30,000 for professional management services received during the year from J.D. J.D. included the $30,000 in its taxable income for its 1997 tax year. On its 1997 return, Clarkston deducted $63,350 for professional management services received from J.D. during that year. J.D. included the $63,350 in its taxable income for its 1998 tax year.

On their 1996 and 1997 returns, Weaver and his wife reported the deductions passed through to them from Clarkston for fees and expenses. On audit, the IRS determined that Clarkston (and thus, the Weavers) could deduct the $30,000 expense in tax year 1997, but not in tax year 1996. It also determined that Clarkston (and, thus, the Weavers) could not deduct $60,000 of the $63,350 expense in tax year 1997.

As of July 31, 1998, Clarkston had not paid J.D. $90,000 in fees and issued J.D. a note for that amount. When J.D. merged into Clarkston as part of a Sec. 368 merger, the $90,000 intercompany note was eliminated by a book entry.

In Tax Court, the Weavers argued that they were entitled to the deductions, because Clarkston had satisfied the Sec. 461(h) all-events test. The IRS disagreed, arguing that Clarkston failed the economic performance prong of the all-events test, because it did not satisfy the Sec. 404(d) timing requirement. In support of Sec. 404(d)s application, the Service noted that (1) Clarkston owed J.D. for services rendered and (2) Clarkston and J.D. arranged to defer the receipt of compensation for those services.

Law

Sec. 461(h) permits accrual-method taxpayers to deduct expenses in the tax year in which the all-events test is satisfied. Under Regs. Sec. 1.461-1(a)(2)(i), the test is met when (1) all events establishing the fact of the liability have occurred; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred as to the liability. For liabilities arising out of a taxpayers receipt of services from another person, economic performance generally occurs under Sec. 461(h)(2)(A)(i) as the services are performed. In certain circumstances, however, economic performance as to a liability for services provided to the taxpayer is not satisfied any earlier than when an amount is otherwise deductible under Sec. 404; see Regs. Sec. 1.461-4(d)(2)(ii)(B).

Sec. 404(d) limits a taxpayers deduction for amounts paid to certain cash-basis independent contractors under a plan or arrangement that defers compensation. Under Temp. Regs. Sec. 1.404(b)-1T, Q&A-2(a), an arrangement defers the receipt of compensation if the service provider does not receive compensation for its services within a brief period of time after the end of the payers tax year in which the services are performed. Temp. Regs. Sec 1.404(b)-1T, Q&A-2(b)(1), provides a rebuttable presumption that a brief period of time is no more than 2¹/2 months after the end of the payers tax year in which the services are performed.

Analysis

The Tax Court concluded that the payment arrangement between Clarkston and J.D. deferred J.D.s receipt of compensation, thereby subjecting Clarkston to the Sec. 404(d) timing rules. Noting that Clarkston did not pay J.D. within 2¹/2 months of the end of the tax year in which the services were performed, the court further concluded that Clarkston failed to meet the Sec. 404(d) timing requirements; thus, Clarkston failed to meet the economic performance prong of the all-events test, thereby preventing the Weavers from deducting the expenses in the years claimed.

The court emphasized that its holding rests on our finding that Clarkson and J.D., whose transactions with each other are subject to particular scrutiny because the two entities are related, had a method or arrangement between them which in substance deferred the receipt of compensation by the service provider. The court also noted that the Weavers offered no proof rebutting the presumption under Temp. Regs. Sec. 1.404(b)-1T, Q&A-2(a), that the arrangement between Clarkston and J.D. deferred compensation.

Conclusion

The application of the Sec. 404 deduction-timing rule to nonindividual independent contractors is often overlooked. For example, fee arrangements between a cash-basis service provider (such as a law firm partnership) and an accrual-basis service recipient often provide that the service providers fees will be paid more than 2¹/2 months after the year in which the services were performed. In such cases, the fees must be treated as deferred compensation; the service recipients deduction must then be deferred until its year in which ends the service providers year in which the fees are includible in the latters income.

Nonetheless, it is not unusual to see the accrual-basis service recipient incorrectly taking a deduction for the year of the services, in accordance with the accrual method. Weaver highlights the issue and confirms that the deferred compensation deduction-timing rule does in fact apply to a fee arrangement with a nonindividual independent contractor.

From Elizabeth Buchbinder, Washington, DC