113 T.C. No. 23
UNITED STATES TAX COURT
USFREIGHTWAYS CORPORATION, f.k.a. TNT FREIGHTWAYS CORPORATION
AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 459-98. Filed November 2, 1999.
P, an accrual method taxpayer, made expenditures during the
1993 taxable year for licenses and insurance which had an
effective period extending into 1994. For purposes of book
accounting and financial reporting, P ratably allocated these
costs over the periods to which they related. For tax accounting
purposes, however, P currently deducted all license and insurance
expenses in the year of payment. Held: On the facts, P, as a
taxpayer utilizing the accrual method, is not entitled to
currently deduct costs benefiting future tax periods in the year
of payment. R’s determination of a deficiency is sustained.
Rex A. Guest and Melvin L. Katten, for petitioner.
Joseph P. Grant and Robin L. Herrell, for respondent.
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OPINION
NIMS, Judge: Respondent determined a Federal income tax
deficiency for petitioner’s 1993 taxable year in the amount of
$1,712,070. After concessions, the issue for decision is whether
petitioner, an accrual method taxpayer, may deduct costs expended
for licenses, permits, fees, and insurance in the year paid
rather than amortizing such costs over the taxable years to which
they relate.
Unless otherwise indicated, all section references are to
sections of the Internal Revenue Code in effect for the year in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
This case was submitted fully stipulated, and the facts are
so found. The stipulations filed by the parties, with
accompanying exhibits, are incorporated herein by this reference.
Background
USFreightways Corporation is, and was at the time of filing
the petition in this case, a Delaware corporation with a
principal place of business in Rosemont, Illinois. USFreightways
and its subsidiaries (hereinafter collectively petitioner) are
engaged in the business of transporting freight for hire by
trucks throughout the continental United States.
Incident to its trucking business, petitioner is required by
State and local government authorities to make expenditures for
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various licenses, permits, and fees (hereinafter collectively
licenses) before its trucks may be legally operated in the
issuing jurisdictions. The licenses are then effective for
specified periods of time. In 1993, petitioner paid $4,308,460
for such licenses. None of these licenses had an effective
period in excess of 1 year, but the expiration date for some fell
within the 1994, rather than the 1993, taxable year.
Similarly, petitioner also purchased liability and property
insurance coverage which extended into future tax years. In
1993, petitioner paid premiums of $1,090,602 for policies
covering the 1-year period from July 1, 1993, to June 30, 1994.
For purposes of Federal income taxes, book accounting, and
financial reporting, petitioner generally employs the accrual
method and a 52/53 week fiscal year. Petitioner’s 1993 fiscal
year ended on January 1, 1994.1 In compiling its financial books
and records for 1993, petitioner expensed the amounts paid in
1993 for licenses and insurance ratably over the 1993 and 1994
years. The license costs were allocated $1,869,564 to 1993 and
$2,438,896 to 1994. The insurance premiums were likewise
1
The deficiency notice determined a deficiency for “Tax
Year Ended” December 31, 1993, and the parties accept this
approach. Consequently, we proceed upon the postulation that
petitioner reported on a calendar year basis.
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allocated $545,301 to 1993 and $545,301 to 1994. Amounts not
expensed in 1993 were reflected as prepayments on petitioner’s
balance sheet.
In preparing its income tax returns, however, petitioner
deducted the full amount expended for licenses and insurance in
the year of payment. Thus, in 1993, deductions of $4,308,460 and
$1,090,602 were taken for licenses and insurance, respectively.
Discussion
We must decide whether petitioner, as an accrual basis
taxpayer, may deduct expenditures for licenses, permits, fees,
and insurance in the year paid or whether deductions for such
costs must be spread ratably over the taxable years to which they
pertain.
Petitioner contends that, because the benefit of the subject
licenses and insurance extends less than 1 year into the
following tax period, the costs do not relate to property having
a useful life substantially beyond the taxable year. Hence,
petitioner argues that the costs do not require capitalization
under section 263 and may be currently deducted as a business
expense under section 162. Further, petitioner asserts that,
although the costs are expensed ratably over 2 years for purposes
of financial records and deducted currently, in 1 year, for tax
purposes, the method of tax accounting used clearly reflects
petitioner’s income within the meaning of section 446.
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Thus, any attempt by respondent to require a change in this tax
accounting method constitutes, in petitioner’s view, an abuse of
discretion.
Conversely, respondent contends that, since a greater
percentage of the costs at issue is allocable to 1994 than to
1993, the expenditures for licenses and insurance do result in
benefits to petitioner extending substantially beyond the taxable
year. Therefore, respondent asserts that the costs must be
capitalized and amortized. In addition, respondent argues that
the distortion in taxable income caused by petitioner’s method of
tax accounting is sufficiently material to require a change in
methods in order to clearly reflect income.
We agree with respondent that petitioner, as an accrual
method taxpayer, is entitled to deduct expenses which are more
than incidental and allocable to future tax years only in the
taxable periods to which they relate.
General Rules
As a threshold premise, section 446(a) states the general
rule: “Taxable income shall be computed under the method of
accounting on the basis of which the taxpayer regularly computes
his income in keeping his books.” The corollary to this rule,
with respect to the timing of deductions, is set forth in section
461(a) and reads: “The amount of any deduction or credit allowed
by this subtitle shall be taken for the taxable year which is the
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proper taxable year under the method of accounting used in
computing taxable income.” Hence, petitioner here, as an accrual
basis taxpayer deducting expenses under the cash or payment
method, is indisputably in contravention of these general rules.
However, income tax regulations implicitly and courts explicitly
recognize that the section 446(a) requirement of conformity
between financial and tax accounting is not absolute. Section
1.446-1(a)(4), Income Tax Regs., implies that deviation may be
permitted by mentioning the need for records to reconcile
differences between books and tax returns. Courts expressly
sanction variations between financial and tax reporting but will
do so only if two criteria are satisfied: (1) Other Code
requirements, such as the deduction and capitalization rules of
sections 162 and 263, must be met, and (2) the method of
accounting must clearly reflect taxable income. See, e.g., Hotel
Kingkade v. Commissioner, 180 F.2d 310, 312-313 (10th Cir. 1950),
affg. 12 T.C. 561 (1949); Coors v. Commissioner, 60 T.C. 368,
392-398 (1973), affd. 519 F.2d 1280 (10th Cir. 1975); Fidelity
Associates, Inc. v. Commissioner, T.C. Memo. 1992-142.
Deduction and Capitalization Rules
On one hand, section 162(a) provides in relevant part:
“There shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business”. Income tax regulations
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interpreting the section further specify that vehicle operating
costs and insurance premiums are among the items that may qualify
as ordinary business expenses. Sec. 1.162–1(a), Income Tax Regs.
On the other hand, section 263(a), entitled Capital
Expenditures, mandates: “No deduction shall be allowed for--(1)
Any amount paid out for new buildings or for permanent
improvements or betterments made to increase the value of any
property or estate.” Regulations then offer the following
explanatory examples: “The cost of acquisition, construction, or
erection of buildings, machinery and equipment, furniture and
fixtures, and similar property having a useful life substantially
beyond the taxable year.” Sec. 1.263(a)-2(a), Income Tax Regs.
The significance of classifying any given expense as either
ordinary or capital lies in the contrasting tax treatments
mandated by the label affixed. As expounded in a recent Supreme
Court analysis of the two sections, “The primary effect of
characterizing a payment as either a business expense or a
capital expenditure concerns the timing of the taxpayer’s cost
recovery: While business expenses are currently deductible, a
capital expenditure usually is amortized and depreciated over the
life of the relevant asset”. INDOPCO, Inc. v. Commissioner, 503
U.S. 79, 83-84 (1992). The purpose of the sections is “to match
expenses with the revenues of the taxable period to which they
are properly attributable, thereby resulting in a more accurate
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calculation of net income for tax purposes.” Id. at 84.
Furthermore, because deductions are matters of “legislative
grace”, “the burden of clearly showing the right to the claimed
deduction is on the taxpayer.” Id. (quoting Interstate Transit
Lines v. Commissioner, 319 U.S. 590, 593 (1943)).
In distinguishing between capital and ordinary costs, the
predominant factor for consideration is whether the payment
creates a future benefit that is more than incidental:
Although the mere presence of an incidental future
benefit–“some future aspect”–may not warrant
capitalization, a taxpayer’s realization of benefits
beyond the year in which the expenditure is incurred is
undeniably important in determining whether the
appropriate tax treatment is immediate deduction or
capitalization. [Id. at 87.]
The creation or enhancement of a separate and distinct asset is
unnecessary. See id. An additional factor weighing in favor of
capital treatment arises where “the purpose for which the
expenditure is made has to do with the corporation’s operations
and betterment, sometimes with a continuing capital asset, for
the duration of its existence or for the indefinite future or for
a time somewhat longer than the current taxable year.” Id. at 90
(quoting General Bancshares Corp. v. Commissioner, 326 F.2d 712,
715 (8th Cir. 1964)).
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Thus, income tax regulations and the Supreme Court both
point to duration of the resultant benefit beyond the current
taxable year as a critical feature for distinguishing between
capital and ordinary.
Petitioner focuses on the “substantially beyond” terminology
in the regulations and argues that this test for capitalization
should be interpreted to mean “more than 1 year beyond the
taxable year”. Current deduction should therefore be allowed
where the benefit of an expenditure extends less than 12 months
into the subsequent tax period. This position, however, has at
least two significant shortcomings.
First, the cases cited by petitioner fail to support any
widespread existence of the rule for which petitioner contends.
As correctly noted by respondent, a significant number of the
cases cited simply hold that expenditures creating a benefit with
a duration in excess of 1 year must be capitalized. See, e.g.,
Jack’s Cookie Co. v. United States, 597 F.2d 395 (4th Cir. 1979);
Bilar Tool & Die Corp. v. Commissioner, 530 F.2d 708 (6th Cir.
1976), revg. 62 T.C. 213 (1974); Clark Oil & Refining Corp. v.
United States, 473 F.2d 1217 (7th Cir. 1973); American Dispenser
Co. v. Commissioner, 396 F.2d 137 (2d Cir. 1968), affg. T.C.
Memo. 1967-153; Fall River Gas Appliance Co. v. Commissioner, 349
F.2d 515 (1st Cir. 1965), affg. 42 T.C. 850 (1964); United States
v. Akin, 248 F.2d 742 (10th Cir. 1957); Hotel Kingkade v.
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Commissioner, 180 F.2d 310 (10th Cir. 1950). They do not
specifically address the proper treatment for assets with a
useful life of less than 1 year, but the benefits of which extend
beyond the years in which the related costs are incurred. See
id.
Moreover, language used in several of these cited cases to
explain the 1-year rule is contrary to petitioner’s position.
For example, in Jack’s Cookie Co. v. United States, supra at 402,
the court stated that the 1-year rule “treats an item as either a
business expense, fully deductible in the year paid, or a capital
expenditure, which is not, depending upon whether it secures for
the taxpayer a business advantage which will be exhausted
completely within the tax year.” Similarly, the court in
American Dispenser Co. v. Commissioner, supra at 138 (quoting
Sears Oil Co. v. Commissioner, 359 F.2d 191, 197 (2d Cir. 1966)),
specified: “The test for whether an item should be treated as a
current expense or as a capital expenditure is whether the
utility of the expenditure survives the accounting period.”
Hence, the focus of the above quotations rests upon whether
the life of the contested benefit exceeds the tax year in which
it is incurred, not whether it endures beyond one 12-month
period. In other cases, again as noted by respondent, no
indication is given as to the intended meaning of the 1-year
terminology employed. See, e.g., Bilar Tool & Die Corp v.
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Commissioner, supra; Clark Oil & Refining Corp. v. United States,
supra; Fall River Gas Appliance Co. v. Commissioner, supra;
United States v. Akin, supra; Hotel Kingkade v. Commissioner,
supra. Thus, widespread support for a rule which would permit
near-automatic deduction for costs related to benefits lasting
less than one 12-month period is lacking.
A second, more fundamental problem with petitioner’s
argument is that even if such a 1-year rule were widely
recognized, it would be inapplicable to an accrual method
taxpayer. Case law requires that a distinction be drawn between
accrual and cash basis taxpayers in situations analogous to that
of petitioner. For instance, even in Zaninovich v. Commissioner,
616 F.2d 429, 431-432 & nn.5-6 (9th Cir. 1980), revg. 69 T.C. 605
(1978), upon which petitioner relies as creating a rule
“[allowing] a full deduction in the year of payment where an
expenditure creates an asset having a useful life beyond the
taxable year of twelve months or less,” the Court of Appeals for
the Ninth Circuit expressly approved the opposite result reached
in Bloedel’s Jewelry, Inc. v. Commissioner, 2 B.T.A. 611 (1925),
on the grounds that the case involved an accrual basis taxpayer.
The issue in Bloedel’s Jewelry was the treatment of a payment
made in 1920 for a lease term running from September 1920 through
August 1921, and the Court of Appeals in Zaninovich v.
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Commissioner, 616 F.2d at 431 n.5, responded to the disallowance
of a current deduction for this lease as follows:
The accrual method of accounting, unlike the cash basis
method, aims to allocate to the taxable year expenses
attributable to income realized in that year. For this
reason, it was appropriate for the lessee in Bloedel’s
Jewelry, supra, to prorate to the next year that
portion of the rental payment which could be matched
with income realized in the next year.
A similar distinction between accrual and cash basis
taxpayers also arises in cases dealing specifically with the
deductibility of insurance expenses. Cash basis taxpayers
typically have been obligated to capitalize payments for
insurance with terms in excess of 1 year but, with respect to
insurance covering 1 year or less, have been permitted full
deduction in the year of payment. See, e.g., Commissioner v.
Boylston Market Association, 131 F.2d 966 (1st Cir. 1942), affg.
B.T.A. Memorandum Opinion dated Nov. 6, 1941; Bell v.
Commissioner, 13 T.C. 344 (1949); Peters v. Commissioner, 4 T.C.
1236 (1945); Jephson v. Commissioner, 37 B.T.A. 1117 (1938);
Kauai Terminal, Ltd. v. Commissioner, 36 B.T.A. 893 (1937). In
contrast, where the taxpayer utilizes the accrual method,
proration of premium expenses has been required, and no
distinction based upon policy length has been articulated. See,
e.g., Johnson v. Commissioner, 108 T.C. 448 (1997), affd. in part
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and revd. in part on other grounds 184 F.3d 786 (8th Cir. 1999);
Higginbotham-Bailey-Logan Co. v. Commissioner, 8 B.T.A. 566
(1927).
For instance, in Johnson v. Commissioner, supra, a taxpayer
employing the accrual method purchased insurance policies
covering periods of 1 to 7 years. Given this scenario, the Court
made no attempt to ascertain which of the policies, such as those
covering only 1 year, would expire within the following taxable
year. Instead, the Court ruled that “to the extent that part of
any Premium was allocable to coverage for subsequent years, it
must be capitalized and amortized by deductions in those years.”
Id. at 488. Likewise, in Higginbotham-Bailey-Logan Co. v.
Commissioner, supra, the Court disallowed a deduction for prepaid
insurance taken by an accrual basis taxpayer without inquiring
into whether the policy might terminate within the next year.
The Court resolved the issue by stating: “The adjustment made by
the Commissioner appears to be in accordance with the method of
accounting employed by the petitioner and appears further to be
such that petitioner’s net income is more nearly correctly
reflected than on the basis used in the return.” Id. at 577.
Hence, beginning as early as 1927 and followed as recently as
1997, reported cases have indicated that an accrual basis
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taxpayer must prorate insurance expenses, and no taxpayer
utilizing such a method has been afforded the treatment that
petitioner here requests.
As a result, consistency with case law negates the
possibility of a 1-year rule with respect to the accrual basis
taxpayer. It follows that petitioner’s deductions were improper
under the rules governing deductions and capitalization.
Clear Reflection of Income Rules
Section 446(b) provides: “If no method of accounting has
been regularly used by the taxpayer, or if the method used does
not clearly reflect income, the computation of taxable income
shall be made under such method as, in the opinion of the
Secretary, does clearly reflect income.” However, petitioner
acknowledges on brief that “The capitalization rules stand on
their own as does the clear reflection of income provision of
I.R.C. section 446(b).” Hence, because petitioner’s treatment of
license and insurance costs violated sections 162 and 263, we
need not reach the issue of whether petitioner’s method of tax
accounting also failed to clearly reflect income. The related
evidentiary objection raised by petitioner, contesting the
admissibility of financial data for years subsequent to 1993, is
likewise rendered moot. The challenged figures were offered only
on the question of clear reflection. Although petitioner asserts
that respondent abused his discretion in changing an accounting
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method authorized by the Code and consistently applied,
petitioner does not argue that a method contrary to law is
nonetheless acceptable so long as it has been consistently
applied.
We therefore hold that petitioner is not entitled to
currently deduct license and insurance expenses allocable to the
following taxable year. Respondent’s determination of a
deficiency with respect to petitioner’s 1993 taxable year is
sustained.
To reflect the foregoing,
Decision will be entered
under Rule 155.