Metro Leasing and Development Corporation, East Bay Chevrolet Company, a Corporation v. Commissioner

119 T.C. No. 2

UNITED STATES TAX COURT

METRO LEASING AND DEVELOPMENT CORPORATION, EAST BAY
CHEVROLET COMPANY, A CORPORATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent*

Docket Nos. 8054-99. Filed July 17, 2002.

In an earlier opinion, we decided that P permitted
its 1995 earnings to accumulate beyond the reasonable
needs of its business. Secs. 531-537, I.R.C. There
remains, however, a dispute concerning the computation
of the accumulated earnings tax. P contends,
alternatively, that R failed to reduce P’s accumulated
earnings tax base by the following amounts: (1)
“Deferred” tax attributable to installment sale
proceeds to be received by P in tax years after 1995;
(2) the amount of the income tax deficiency determined
by respondent which remains contested by P and for
which P has made payment after filing its petition; and
(3) the difference between the amount of tax liability
reported on P’s return and the amount of tax that would
have been due on P’s net capital gain.

*
This Opinion supplements a previously released opinion:
Metro Leasing & Dev. Corp., East Bay Chevrolet Co., A Corporation
v. Commissioner, T.C. Memo. 2001-119.
 - 2 -

All three reductions proposed by P require our
interpretation of sec. 535(b), I.R.C. Proposed
reductions (1) and (2) involve the interpretation of
sec. 535(b)(1), I.R.C., and sec. 1.535-2(a)(1), Income
Tax Regs. Reduction (3) involves sec. 535(b)(6),
I.R.C. Reductions (1) and (3) present questions of
first impression. With respect to reduction (2), this
Court’s decision on the issue was reversed by the Court
of Appeals for the Fifth Circuit in J.H. Rutter Rex
Manufacturing Co. v. Commissioner, 853 F.2d 1275 (5th
Cir. 1987), revg. on this point T.C. Memo. 1987-296.
If we follow the holding of the Court of Appeals, P
would be entitled to a reduction for the paid, but
still contested, income tax deficiency. R urges this
Court not to follow the holding of the Court of
Appeals.
Held: This Court will not follow the holding of
Court of Appeals on this point in Rutter Rex. Held,
further, sec. 535(b), I.R.C., and underlying
regulations are interpreted, and R’s computation of P’s
accumulated earnings tax liability is correct.

William L. Raby, for petitioner.

Kathryn K. Vetter, for respondent.

SUPPLEMENTAL OPINION1

GERBER, Judge: In an earlier opinion, we decided that

petitioner permitted its 1995 earnings to accumulate beyond the

1
On May 18, 2001, this Court filed a Memorandum Findings Of
Fact And Opinion, Metro Leasing & Dev. Corp., East Bay Chevrolet
Co., A Corporation v. Commissioner, T.C. Memo. 2001-119, in two
consolidated cases (docket Nos. 8054-99 and 8055-99) stating that
decisions would be entered pursuant to Rule 155 of the Court’s
Rules of Practice and Procedure in both docket numbers. On Sept.
20, 2001, in docket No. 8055-99, Respondent’s Computation For
Entry Of Decision (together with a proposed decision document)
was filed. On Oct. 3, 2001, by order of this Court, the
consolidated cases at docket No. 8054-99 and docket No. 8055-99
were severed. On Oct. 5, 2001, a decision was entered in docket
No. 8055-99.
 - 3 -

reasonable needs of its business. See secs. 531-537;2 Metro

Leasing & Dev. Corp. v. Commissioner, T.C. Memo. 2001-119. We

also decided the amount of reasonable compensation for

petitioner’s officers. To reflect our holding and to adjust for

agreed items, the parties were required to compute the amount of

resulting income tax and accumulated earnings tax liabilities

pursuant to Rule 155 computation procedures.

The parties, in docket No. 8054-99, disagree about the

computation of the accumulated earnings tax liability. That tax

liability is computed by applying the accumulated earnings tax

rate to a corporation’s accumulated taxable income. Accumulated

taxable income is computed by making certain adjustments to

taxable income. Respondent computed a proposed accumulated

earnings tax liability of $56,248, and petitioner disagreed,

contending that three additional adjustments should be made to

respondent’s computation. If any of petitioner’s proposed

adjustments are sustained, the resulting accumulated earnings tax

liability would be within a range of amounts from zero to

$51,074.

Petitioner argues that, in computing accumulated taxable

income, respondent failed to reduce taxable income by the

2
All section references are to 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, unless otherwise
indicated.
 - 4 -

following items: (1) Income tax attributable to unrealized and

unrecognized installment sale proceeds (if correct, this

adjustment would result in no accumulated earnings tax

liability); (2) the amount of the income tax deficiency either

determined by respondent or decided by this Court (resulting in

no liability or $13,666 in accumulated earnings tax,

respectively); and (3) an increased reduction under section

535(b)(6), if any accumulated earnings tax liability results

after our consideration of proposed adjustments (1) and (2).

I. Tax Liability on Installment Sale Income To Be Received in
Years After 1995

Section 531 imposes a tax on a corporate taxpayer’s

accumulated taxable income. Accumulated taxable income is

computed by making certain adjustments to a corporate taxpayer’s

taxable income. Sec. 535(a). In particular, section 535(b)(1)

permits a deduction for Federal income tax “accrued during the

taxable year”. In approaching this deduction, petitioner argues

that its tax liability on unrealized and unrecognized installment

sale income had accrued. This issue is one of first impression

in the context of computing accumulated taxable income.

During its 1995 tax year, petitioner sold improved real

property. The gross profit from the sale was $1,569,211.
 - 5 -

Petitioner reported the sale under the installment method.3

Under that method, a taxpayer reports the taxable portion of each

installment in the year received. Petitioner received $28,376 in

installments for 1995, of which only $20,303 was included in

income by petitioner on its 1995 Federal income tax return.

Petitioner “deferred” the inclusion in income of the remainder of

the $1,569,211 installment sale gross profit until future

installments were paid/received.4

In arguing that the tax on future installment income had

“accrued”, petitioner relies on section 1.535-2(a)(1), Income Tax

Regs. That regulation contains the following elaboration on the

deduction as being “for taxes accrued during the taxable year,

regardless of whether the corporation uses an accrual method of

accounting, the cash receipts and disbursements method, or any

other allowable method of accounting.”

3
Petitioner’s 1995 Federal return contains the notation
that it uses the accrual method of accounting for tax purposes.
With respect to the real estate sale, however, petitioner elected
the installment method.
4
Petitioner reflected an amount in excess of $500,000 in
connection with the installment sale as “deferred income taxes”
(a current liability) on the balance sheet which was part of its
1995 return. In addition, for financial reporting purposes,
petitioner included the “deferred” installment sale income in its
1995 income. However, no part of the income that may be realized
from subsequent years’ installments was included in petitioner’s
1995 Federal income tax base.
 - 6 -

According to petitioner, the quoted phrase changes all

taxpayers’ methods of reporting income for purposes of section

535(b)(1) to the accrual method. Petitioner contends that the

phrase “regardless of whether the corporation uses an accrual

method of accounting, the cash receipts and disbursements method,

or any other allowable method of accounting” modifies the

statutory phrase “taxes accrued during the taxable year”. In

other words, petitioner argues that the taxes that accrued during

the 1995 year should include future years’ installment sale

income as though petitioner had reported the entire sale under

the accrual method for 1995. Computing the accrued tax in the

manner proposed by petitioner would result in no accumulated

taxable income and, therefore, no accumulated earnings tax

liability.

Respondent disagrees with petitioner and points out that the

language of section 1.535-2(a)(1), Income Tax Regs., was not

intended to change petitioner’s method for reporting income from

the installment to the accrual method. In that regard,

respondent contends that section 535(b)(1) and the underlying

regulation concern the amount of tax that “accrued during the

taxable year”. Respondent also contends that petitioner’s post-

1995 installment sale income does not meet the well-established

standard for accrual of the income and/or tax during petitioner’s

1995 Federal tax year.
 - 7 -

We agree with respondent. The regulation permits petitioner

to deduct its tax liability which had accrued but had not been

paid by the end of 1995. The regulation does not change

petitioner’s tax accounting method for reporting income.

Respondent’s interpretation of the regulation would result in

equal treatment for corporate taxpayers with respect to the

accrual of a tax liability for the year(s) under consideration.5

Petitioner’s interpretation, for purposes of computing

accumulated taxable income, would place all taxpayers on the

accrual method for reporting income.6

We find petitioner’s approach to be inherently inconsistent

with and contradictory to the statutory scheme, especially when

considered in the factual context of this case. In that regard,

petitioner seeks the benefit of a reduction attributable to tax

on unrealized installment sale income in computing accumulated

5
For example, under the cash method a taxpayer’s tax
liability would not be deductible until such time as it is paid.
Under respondent’s interpretation, a cash basis taxpayer would be
entitled to deduct unpaid, but established (“accrued”), income
tax liability that, but for payment, had accrued during the
taxable year.
6
Under petitioner’s interpretation of the statute, its
sales transaction would have to be treated as an accrual method
transaction as though the installment reporting method had not
been elected.
 - 8 -

taxable income. Petitioner, however, has not included any

portion of that same income in its tax base for 1995.7

Petitioner’s interpretation of the subject regulation does

not comport with the section 535 statutory phrase “accrued during

the taxable year”. In addition, the modification of a taxpayer’s

overall tax accounting method does not appear to fit within the

regimen of section 535(b). “The adjustments prescribed by

section 535(a) and (b) are designed generally to assure that a

corporation’s ‘accumulated taxable income’ reflects more

accurately than ‘taxable income’ the amount actually available to

the corporation for business purposes.” Ivan Allen Co. v. United

States, 422 U.S. 617, 626 (1975).

The adjustments provided for in section 535(b) increase or

decrease taxable income, on an annualized basis, to arrive at a

base against which to apply the accumulated earnings tax of

section 531. For example, section 535(b)(1) provides for a

reduction for taxes accrued during the taxable year and section

535(b)(4) requires that net operating loss deductions from other

7
For example, if petitioner had included the income in its
tax base for 1995, its taxable income (the starting point for
computing accumulated taxable income) would have been
proportionately larger and, even after the reduction for the
“accrued tax” on future installment income, would have had the
potential to result in a larger accumulated earnings tax than the
$56,248 computed by respondent. In effect, petitioner seeks to
reduce the accumulated taxable income base by the future tax
liability without including the future income in the income
accumulation for the 1995 tax year.
 - 9 -

years must be added back. The purpose of these adjustments is to

find the amount by which income has been allowed to accumulate

beyond the needs of the business for a particular tax year.

Respondent’s interpretation of the regulatory phrase accomplishes

that end. Petitioner’s interpretation, on the other hand,

addresses the question of future tax liability.8

Under established tax accounting principles for accrual, a

liability is incurred and/or taken into account in the year in

which all the events have occurred that establish the fact of the

liability. See sec. 1.461-1(a)(2), Income Tax Regs. All the

events have occurred when the amount of the liability can be

determined with reasonable accuracy and economic performance has

occurred with respect to the liability. Id. All of the events

have not occurred with respect to petitioner’s tax liability on

future years’ installment sale income. Accordingly, petitioner

is not entitled to deduct tax on post-1995 installment sale

income from taxable income in arriving at accumulated taxable

income for 1995.

8
To the extent that petitioner receives installment income
in future years, the tax and income would be matched in the same
taxable year and have a direct bearing on whether that income was
allowed to accumulate beyond its needs for that future year.
 - 10 -

II. Whether a Contested Income Tax Deficiency That Has Been Paid
Is Deductible From Taxable Income in Arriving at Accumulated
Taxable Income

Here again, we focus on section 535(b)(1) and the underlying

regulation in considering whether a contested income tax

deficiency is a tax that “accrued during the taxable year”.

Petitioner reported an income tax liability of $2,674 on its 1995

corporate Federal income tax return. The $2,674 was remitted by

petitioner during March 1996, when it filed its 1995 return.

Thereafter respondent determined a deficiency in petitioner’s

income tax and, in addition, that petitioner was subject to the

accumulated earnings tax. After the petition was filed and

before we issued our opinion, petitioner tendered payment of the

income tax deficiency to respondent. Although petitioner

tendered payment, it continues to contest the income tax

deficiency. The parties disagree with respect to whether any

part of the income tax deficiency should be deducted from taxable

income to arrive at accumulated taxable income, the base for the

accumulated earnings tax.

In making the adjustments to taxable income to arrive at

accumulated taxable income, respondent deducted the $2,674 tax

liability reported by petitioner, even though the $2,674 was not

paid until after the close of the 1995 tax year. In addition to

the $2,674, petitioner argues that the income tax deficiency,

either in the amount determined by respondent or decided by the

Court, should also be deducted from taxable income to reduce the
 - 11 -

accumulated earnings tax base.9 Respondent disagrees, contending

that the income tax deficiency did not accrue during the taxable

year as required by section 535(b)(1) because petitioner

continues to contest it. In support of his argument, respondent

relies on the well-established standards for accrual (the “all

events test”), contending that a contested tax liability does not

meet that test.

Petitioner relies on the holding in J.H. Rutter Rex

Manufacturing. Co. v. Commissioner, 853 F.2d 1275 (5th Cir.

1988), revg. T.C. Memo. 1987-296 (Rutter Rex).10 The rationale

of that case focuses on the word “unpaid” in section 1.535-

9
A taxpayer’s Federal income tax liability is not
deductible in arriving at taxable income. See sec. 275. A
Federal income tax liability that “accrued during the taxable
year” is allowed as a deduction from the tax base for the
accumulated earnings tax. See sec. 535(b)(1).
10
Our J.H. Rutter Rex Manufacturing Co. v. Commissioner
opinion (T.C. Memo. 1987-296) (Rutter Rex) was reversed during
1988 (Rutter Rex, 853 F.2d 1275 (5th Cir. 1988). We consider in
this opinion whether we will follow the holding of the Court of
Appeals for the Fifth Circuit or adhere to our established
holding on this question. Since the reversal, this point has not
been addressed by this Court or any other court. Any appeal of
our decision in these consolidated cases would normally lie with
the Court of Appeals for the Ninth Circuit because petitioner’s
principal place of business was in California. See sec.
7482(b)(1)(B). The Court of Appeals for the Ninth Circuit has
not addressed the question we consider here. Even though this
Court may disagree with an appellate court holding that is
squarely on point, we shall follow the appellate court holding if
that court is the venue for appeal. See Golsen v. Commissioner,
54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971).
 - 12 -

2(a)(1), Income Tax Regs.,11 to reach the conclusion that a

contested12 income tax deficiency that has been paid is

deductible within the meaning of section 535(b)(1). Rutter Rex,

supra at 1296. We note that the Court of Appeals for the Fifth

Circuit did not invalidate section 1.535-2(a)(1), Income Tax

Regs., in the process of reaching its holding. The factual

predicates for the taxpayer in Rutter Rex and petitioner are

substantially identical.13

11
The word “unpaid” appears in the last sentence of the
pertinent part of sec. 1.535-2(a)(1), Income Tax Regs., as
follows:

for taxes accrued during the taxable year, regardless
of whether the corporation uses an accrual method of
accounting, the cash receipts and disbursements method,
or any other allowable method of accounting. In
computing the amount of taxes accrued, an unpaid tax
which is being contested is not considered accrued
until the contest is resolved.

(Emphasis supplied.)
12
In its opinion, the Court of Appeals acknowledged that
the income tax deficiency remained in controversy, even though
payment had been proffered. Accordingly, the Court was aware
that, ultimately, the taxpayer’s accumulation might not have been
subjected to the contested tax deficiency.
13
The taxpayer in Rutter Rex petitioned this Court to
contest income and accumulated earning tax deficiencies
determined by the Commissioner. After the filing of the petition
and this Court’s opinion as to the amount of the income tax
deficiency, but prior to the final computation of the accumulated
earning tax and the entry of a decision, the taxpayer “apparently
offered to pay” the contested income tax deficiencies. See
Rutter Rex, 853 F.2d at 1295. We surmise from the quoted
language that the deficiency under consideration in Rutter Rex
had not been assessed. Likewise, in the case we consider,
(continued...)
 - 13 -

The Court of Appeals for the Fifth Circuit emphasized in its

rationale

that the accumulated earnings tax is a penalty tax and
thus is to be strictly construed. Ivan Allen Co., 422
U.S. at 626, 95 S. Ct. at 2506. Due to the special
nature of the accumulated earnings tax and its focused
examination of earnings accumulated in a given year, it
would be inequitable and inconsistent not to allow a
corporation to deduct taxes assessed and attributable
for the year at issue, even though the corporation may
be contesting the taxes, as long as the corporation has
paid the taxes prior to the final computation of its
accumulated earnings tax liability. * * * [Rutter Rex,
supra at 1296.]

We respectfully disagree with the interpretation of the

Court of Appeals for the Fifth Circuit of section 1.535-2(a)(1),

Income Tax Regs. That regulation, in its amplification of the

language “tax accrued during the taxable year”, is designed to

permit a reduction from taxable income in arriving at accumulated

taxable income for a tax liability that had accrued during the

taxable year, but had not been paid (is “unpaid”). That final

caveat of the regulation simply explains that an accrued but

unpaid tax liability may not be used to reduce the base for the

accumulated earnings tax, if the tax is contested. The focus of

that final caveat is that no deduction is permissible where the

liability is contested. The Court of Appeals, however,

13
(...continued)
respondent’s computation reflects that petitioner’s payment, in
the amount of $326,932, had been paid but not assessed.
 - 14 -

interpreted the term “unpaid” as the focus of the regulation’s

caveat and its controlling condition.

Petitioner argues that the result fashioned by the Court of

Appeals in Rutter Rex is more equitable. We observe, however,

that it is inconsistent in that it treats a paid but contested

deficiency differently from one that is unpaid and contested. In

either situation, there is no way to know whether a taxpayer’s

earnings will ultimately bear the burden of the contested

deficiency determination. The payment of a contested income tax

deficiency does not overcome the requirement that the obligation

be fixed or final for accrual.14

Petitioner argues that traditional accrual concepts (“all

events test”) should not be employed for determining income tax

accrued in the computation of accumulated taxable income.

Petitioner’s argument is based on the appellate court’s rationale

in Rutter Rex that it would be inequitable to prohibit a

reduction for a paid, but contested, tax deficiency. Petitioner,

however, has not provided a policy reason to treat taxpayers who

14
In addition, from the perspective of the accumulated
earnings tax, payment of a contested income tax deficiency some 5
or 6 years after the accumulation in question would appear to
have little relevance to the question of whether the tax “accrued
during the taxable year” or whether a taxpayer allowed its income
to accumulate beyond the reasonable needs of the business. The
quoted statutory language and the regimen of the accumulated
earnings tax address the proscribed accumulation at the time of
the accumulation.
 - 15 -

contest an unpaid income tax deficiency differently from

taxpayers who choose or are able to pay a contested deficiency.

Our holding in Rutter Rex, T.C. Memo. 1987-296, was

consistent with our holding in Doug-Long, Inc. v. Commissioner,

73 T.C. 71 (1979), which, in turn, followed the Supreme Court’s

reasoning in Dixie Pine Prods. Co. v. Commissioner, 320 U.S. 516

(1944), and related precedent. See also Estate of Goodall v.

Commissioner, 391 F.2d 775 (8th Cir. 1968). Those cases follow

traditional accrual principles holding that a contested tax

liability is not deductible because it has not accrued.

In Doug-Long, Inc. v. Commissioner, supra, we held that the

questioned phrase in the regulation was a valid interpretation of

section 535 when determining a corporation’s Federal income tax

that had accrued during the taxable year. The Commissioner has

also provided guidance on this point, consistent with his

position that contested deficiencies may not be reduced from the

accumulated earnings tax base. See Rev. Rul. 72-306, 1972-1 C.B.

166. Moreover, the rationale employed in the Rutter Rex

appellate opinion rests upon perceived inequities and varies from

the requirements of section 461(f) and traditional accrual

principles.15 In that regard, the Court of Appeals for the

15
The Court of Appeals for the Fifth Circuit, in a
footnote, also acknowledged that their holding was contrary to
cases interpreting the phrase “taxes * * * accrued during the
taxable year” in the context of personal holding tax cases under
(continued...)
 - 16 -

Eighth Circuit, relying on Dixie Pine Prods. Co. v. Commissioner,

320 U.S. 516 (1944), held that the all events test applied in

deciding “what may be regarded as Federal income taxes of the

corporation properly ‘paid or accrued during the taxable year’”.

Estate of Goodall v. Commissioner, supra at 800.

Significantly, Congress in section 535(b) has specifically

provided for adjustments that cause the accumulated earnings tax

to be applied or not to be applied to various items. There is no

indication that Congress intended that the term “accrual” have a

different meaning for purposes of section 535(b) and section

1.535-2(a)(1), Income Tax Regs., than its traditional and well-

established meaning. In that context, we interpret the last line

of section 1.535-2(a)(1), Income Tax Regs., as simply explaining

that an accrued but unpaid tax liability may not be used to

reduce the base for the accumulated earnings tax, if the tax is

contested.16 Accordingly, in a situation where a taxpayer

15
(...continued)
secs. 541-547, a companion penalty regimen. See LX Cattle Co. v.
United States, 629 F.2d 1096 (5th Cir. 1980); Kluger Associates,
Inc. v. Commissioner, 617 F.2d 323 (2d Cir. 1980), affg. 69 T.C.
925 (1978); Hart Metal Prods. Corp. v. Commissioner, 437 F.2d 946
(7th Cir. 1971), affg. T.C. Memo. 1969-164; Mariani Frozen Foods,
Inc. v. Commissioner, 81 T.C. 448 (1983), affd. sub nom. Gee
Trust v. Commissioner, 761 F.2d 1410 (9th Cir. 1985). For
additional discussion by the Court of Appeals on this point, see
Rutter Rex, 853 F.2d at 1297 n.37.
16
Although not decisive, it is interesting to note that in
the context of a prepayment forum, the income tax deficiency is
not assessed and, as a technical matter, could not be paid. By
(continued...)
 - 17 -

contests the Commissioner’s determination and may continue to

contest it after our decision is entered, the “all events test”

has not been met. Our prior holdings and those of the Supreme

Court support that result.

For those reasons, we disagree with the holding and

rationale of the Court of Appeals for the Fifth Circuit and

continue to adhere to our established precedent. We hold that no

part of petitioner’s paid, but contested, income tax deficiency

should be reduced from its taxable income in arriving at

accumulated taxable income under section 535(b)(1).

III. Whether the Amount of the “Tax Attributable” Adjustment to
Capital Gains That Is Used To Arrive at the Accumulated Earnings
Tax Base Should Be Limited to Petitioner’s Reported Tax Liability
for the Year

Petitioner argues, as its third and final alternative, that

respondent’s computation of the adjustment for capital gains is

understated. Petitioner argues that the tax attributable

adjustment should be limited to the actual overall tax liability

reported or a duplication of tax burden would result. Respondent

contends that his adjustment follows the literal requirements of

section 535(b)(6)(A).

16
(...continued)
contesting the deficiency, a taxpayer ensures that the tax may
not be assessed or collected. Even though a deficiency is paid
after the filing of a petition, if a taxpayer continues to
contest it, the tax is not assessed. Normally, payment during
the course of a prepayment (deficiency) forum is used to stop the
running of interest and is treated more like a deposit should an
income tax deficiency be ultimately decided.
 - 18 -

Section 535(b)(6)(A) provides for a deduction from taxable

income in arriving at accumulated taxable income of “the net

capital gain * * * reduced by * * * the taxes attributable to

such net capital gain.” Section 535(b)(6)(B) defines “the taxes

attributable to the net capital gain” as the difference between

“the taxes imposed by this subtitle (except the tax imposed by

this part) for the taxable year, and * * * such taxes computed

for such year without including in taxable income the net capital

gain for the taxable year”.

The section 535(b)(6)(B)(i) language “the taxes imposed by

this subtitle”, is the focus of the parties’ dispute. Petitioner

contends that the “taxes imposed” should be limited to the amount

of tax liability it reported on its 1995 return or $2,674. On

the other hand, respondent’s computation is based on “taxes

imposed” of $110,203, the amount of income tax this Court decided

is imposed under the statute.

In applying the above-quoted adjustment in his Rule 155

computation, respondent computed the accumulated earnings tax as

follows:17

17
There appear to be two errors in respondent’s computation
of petitioner’s accumulated earnings tax. First, there appears
to be an error in subtraction. If $325,000 is reduced by $2,674
and $24,616, the result should be $297,710 and not $300,384.
Second, the amount shown as taxable income on Form 5278,
Statement--Income Tax Changes, of respondent’s computation is
$325,522 and not $325,000. The parties will be asked to address
these apparent discrepancies in a Rule 155 computation to be
prepared in accord with this Supplemental Opinion.
 - 19 -

Accumulated Earnings Tax-1995

Taxable income per Form 5278 $325,000
Less sec. 535(b) adjustments:
1. Federal income taxes accrued (2,674)
2. Net capital gains 40,354
less: income tax attribu-
table thereto 15,738
(24,616)
300,384
Less dividends paid:
Compensation treated as dividend (150,250)
Other expenses paid for benefit
of shareholders (8,094)

Accumulated taxable income 142,040

x 39.6% 56,248

In the above computation, respondent has interpreted section

535(b)(6) to mean that the net capital gain should first be

reduced by the full amount of tax on the capital gain and that it

is not limited by the amount of combined tax liability reported

by petitioner for 1995. Accordingly, respondent has taken the

net capital gain of $40,354, applied the 35-percent maximum rate

under section 1201 and arrived at $15,738 of income tax

attributable to the net capital gain.18 After making the “tax

attributable” adjustment, respondent reduced taxable income by

the $24,616 difference in the process of arriving at accumulated

taxable income.

18
We note that petitioner reported $35,884 of net capital
gain and that respondent made adjustments increasing the amount
to $40,354. We also note that 35 percent of $40,354 is
$14,123.90 ($14,124) and not $15,738. It appears that another
adjustment was combined with the one discussed herein, resulting
in the $15,738 amount.
 - 20 -

Petitioner argues that if the “total amount of Federal

income tax attributable to the year 1995 for purposes of the

section 535(b)(1) calculation is determined to be $2,674, * * *

then the total amount of income tax attributable to the capital

gain cannot logically exceed $2,674.” In other words, petitioner

contends that respondent’s net capital gain deduction from

taxable income in the process of arriving at accumulated taxable

income is $13,064 too small.19

The question raised by petitioner’s argument is whether the

amount of tax, in the context of the section 535(b)(6) phrase tax

“attributable to the net capital gain”, is limited by the amount

of a taxpayer’s total combined income tax liability20 that was

reported for the year. This is a question of first impression.

In order to understand better the distinctions between the

parties’ positions, we review petitioner’s 1995 Form 1120, U.S.

Corporation Income Tax Return. Petitioner reported “Total

Income” of $898,479, of which $35,884 was reported as “Capital

gain net income”. The remainder of the income reported appears

to be from sources of “ordinary income”, such as rents,

royalties, etc. After ordinary deductions of $844,327 and a

19
In support of its position, petitioner argues that
respondent’s approach results in a duplication or “doubling-up of
the tax element”. Essentially, respondent’s computation results
in removing the capital gain and its tax effect from the tax base
for computing accumulated earnings tax.
20
The liability when considering both ordinary and net
capital gain income.
 - 21 -

$36,326 net operating loss deduction, petitioner reported taxable

income of only $17,825.

The $17,825 of taxable income reported by petitioner

resulted in a $2,674 tax liability. It is that $2,674 which

petitioner argues should limit the “tax attributable” to net

capital gains within the meaning of section 535(b)(6). We note

that the $2,674 of tax liability reported by petitioner has

already been deducted from taxable income in the process of

arriving at accumulated taxable income.21

The problem with petitioner’s position is that $2,674 is not

the “tax imposed” on petitioner’s 1995 taxable income. The tax

imposed on petitioner’s 1995 taxable income is $110,203, the

amount decided by this Court in our earlier opinion Metro Leasing

& Dev. Corp. East Bay Chevrolet Co. v. Commissioner, T.C. Memo.

2001-119, which concerned the underlying tax issues. The

$110,203 amount decided by this Court is the tax imposed under

section 535(b)(6)(B)(i). If $110,203 is used as the tax imposed

in the section 535(b)(6) calculation, respondent’s computation of

accumulated taxable income is correct.

Section 535(b) contains several adjustments, some of which

are intended to remove certain items from the accumulated

earnings tax base. In that regard, section 535(b)(5),(6), and

(7) provides for adjustments pertaining to capital gains. In

21
That adjustment was made under sec. 535(b)(1) as
discussed earlier in this Opinion.
 - 22 -

general, section 535(b)(5) permits a reduction for net capital

losses for the taxable year. Section 535(b)(6) provides for a

reduction for net capital gains, less tax attributable to said

gains. Finally, section 535(b)(7) makes inapplicable the

ordering rules for capital losses under section 1212 and provides

for the carryover of the prior year’s net capital loss.

The net effect of the provisions regarding capital gains and

losses is to remove them from the accumulated earnings tax base,

irrespective of whether they resulted in gain or loss.

Respondent has removed the net capital gains in accord with the

statute. The limitation argued for by petitioner does not

comport with the statute, because the amount of tax liability

reported by petitioner is not, ultimately, the “tax imposed” by

the statute.

A similarly worded adjustment and computation for removing

net capital gains from the computation of the personal holding

company tax is provided for in section 545(b)(5). Like the

accumulated earnings tax, the personal holding tax is considered

a “penalty” tax. Taxpayers, in the context of the personal

holding tax, have made arguments similar to those made by

petitioner in this case. They argued that the tax imposed should

equal the tax accrued for purposes of the capital gain

adjustment. This Court rejected those arguments, holding that

Congress was aware that taxpayers would not be able to deduct
 - 23 -

contested taxes in connection with the adjustment for “taxes

accrued during the year”, whereas the tax imposed would include

the deficiency decided by a court. See Kluger Associates, Inc.

v. Commissioner, 69 T.C. 925, 940-941 (1978), affd. 617 F.2d 323,

333 (2d Cir. 1980); Ellis Corp. v. Commissioner, 57 T.C. 520, 523

(1972).

We are aware of the paradox that has been occasioned by

petitioner’s choice to continue contesting the income tax

deficiency. That choice has resulted in petitioner’s inability

to treat the income tax deficiency, decided by this Court, as

accrued during the taxable year for purposes of the section

535(b)(1) adjustment. Conversely, petitioner may not use the

$2,674 tax liability it originally reported in its computation of

the section 535(b)(6) adjustment. Although the two items are

conceptually related, by definition they are not interdependent.

For the section 535(b)(1) adjustment, the tax must have accrued.

Whereas the section 535(b)(6)(B)(i) aspect of the capital gain

adjustment is dependent upon the amount of the tax imposed. The

tax “imposed” and the tax “accrued” for a particular year could

be the same amount. But where the tax “imposed” is contested, it

is not treated as “accrued”.

We therefore hold that respondent correctly computed the

adjustment for net capital gains under section 535(b)(6) and that
 - 24 -

respondent’s approach to the Rule 155 computation is not in

error.

To reflect the foregoing,

Decision will be entered

under Rule 155.

Reviewed by the Court.

WELLS, COHEN, SWIFT, WHALEN, COLVIN, HALPERN, BEGHE,
CHIECHI, FOLEY, VASQUEZ, GALE, THORNTON, and MARVEL, JJ., agree
with the majority opinion.

RUWE and LARO, JJ., did not participate in consideration of
this case.
 - 25 -

HALPERN, J., concurring: Although I have joined in the

majority’s opinion, I write separately to set forth more fully

why I believe petitioner may not accrue the contested tax

liability in question.

I. Application of the All Events Test

The majority notes: “Our holding in J.H. Rutter Rex

Manufacturing Co. v. Commissioner, T.C. Memo. 1987-296, was

consistent with our holding in Doug-Long, Inc. v. Commissioner,

73 T.C. 71 (1979), which, in turn, followed the Supreme Court’s

reasoning in Dixie Pine Prods. Co. v. Commissioner, 320 U.S. 516

(1944), and related precedent.” Majority op. p. 15. It is upon

Dixie Pine Prods. Co. and the “related precedent” that I wish to

focus.

The seminal case establishing the basic rule for when a

liability is incurred and, thus, is taken into account under the

accrual method of accounting for Federal income tax purposes is

United States v. Anderson, 269 U.S. 422 (1926), which holds that

a liability is incurred in the year in which occur all the events

needed to create an unconditional obligation to pay such

liability. That test (the all events test) is now embodied in

section 1.446-1(c)(1)(ii)(A), Income Tax Regs., which provides

that, under an accrual method of accounting (in addition to the

requirement of “economic performance”, added in 1984), a

liability is incurred for income tax purposes “in the taxable
 - 26 -

year in which all the events have occurred that establish the

fact of the liability, [and] the amount of the liability can be

determined with reasonable accuracy”. See also sec. 1.461-

1(a)(2), Income Tax Regs.

In Dixie Pine Prods. Co. v. Commissioner, supra, the Supreme

Court amplified the all events test by holding that all of the

events to establish a liability have not occurred if the

liability is contingent and is contested by the supposed obligor.

Id. at 519; accord Security Flour Mills Co. v. Commissioner, 321

U.S. 281 (1944).1 In Dixie Pine Prods. Co. v. Commissioner,

supra, the taxpayer had contested a State excise tax that,

otherwise, would have been due for the taxable year in question.

The Supreme Court held that the taxpayer could claim a deduction

only for the taxable year in which its liability for the tax was

finally settled. Id. at 519.

In United States v. Consol. Edison Co., 366 U.S. 380 (1961),

the Supreme Court applied the all events test to a situation in

which a contested real estate tax liability was paid in order to

1
It should be noted that, in the absence of a contest, the
all events test is satisfied with respect to the additional tax
attributable to an income tax deficiency as of the close of the
deficiency year. See Dravo Corp. v. United States, 172 Ct. Cl.
200, 348 F.2d 542 (1965) (additional State capital stock tax paid
without protest by accrual method taxpayer in year 3 with respect
to year 1 properly accruable for year 1). Such additional tax
is, therefore, properly accruable for the deficiency year under
sec. 535(b)(1). Rev. Rul. 68-632, 1968-2 C.B. 253.
 - 27 -

stay the seizure and sale of the property (in satisfaction of the

tax lien) during the pendency of the contest. The Court held

that such payment did not satisfy the all events test so long as

the contest was still pending. Id. at 391-392.

The result in United States v. Consol. Edison Co., supra,

was overruled (retroactively to the effective date of the 1954

Code) by section 223 of the Revenue Act of 1964, Pub. L. 88-272,

78 Stat. 19, 76, which added section 461(f), which permits a

deduction for contested items in the year of payment, even though

the contest is not resolved until a later year. S. Rept. 830,

88th Cong., 2d Sess. (1964), 1964-1 C.B. (Part 2) 505, is the

report of the Committee on Finance that accompanied H.R. 8363,

88th Cong., 1st Sess. (1963), which, when enacted, became the

Revenue Act of 1964. The report explains the general reasons for

section 461(f) (which originated in the Senate) as follows:

Although your committee does not question the legal
doctrine laid down by the Supreme Court in the
Consolidated Edison case, it believes that it is
unfortunate to deny taxpayers a deduction with respect
to an item where the payment has actually been made,
even though the liability is still being contested
either as to amount or as to the item itself. * * *

S. Rept. 830, 88th Cong., 2d Sess. (1964), 1964-1 C.B. (Part 2)

505, 604. (Emphasis added.)

Thus, under well-established principles of tax accrual laid

down by the Supreme Court, it is clear that, for income tax

purposes, the all events test is not satisfied with respect to a

contested tax liability, and the contested tax liability may not
 - 28 -

be “accrued”, until the year in which the contest is terminated.

If the contested liability is paid before the contest is

terminated, the liability is deductible in the year of payment

pursuant to section 461(f). If the same tax accrual principles

apply for purposes of section 535(b)(1), there is no basis in law

for the holding of the Court of Appeals for the Fifth Circuit in

J.H. Rutter Rex Manufacturing Co. v. Commissioner, 853 F.2d 1275

(5th Cir. 1988), revg. T.C. Memo. 1987-296, that a taxpayer’s

payment of a contested tax liability entitles the payor to treat

the contested liability as “accrued” during the prior taxable

year to which the accumulated earnings tax relates.

II. Relevance of Sec. 1.535-2(a)(1), Income Tax Regs.

The Court of Appeals for the Fifth Circuit, in J.H. Rutter

Rex Manufacturing Co. v. Commissioner, supra at 1297, noted that

the last sentence of section 1.535-2(a)(1), Income Tax Regs.,

does not prohibit an accrual deduction for paid contested taxes

prior to termination of the contest because the sentence provides

only that “an unpaid tax which is being contested is not

considered accrued until the contest is resolved.” (Emphasis

added.) In reaching that conclusion, the Court of Appeals

overlooked the fact that, at the time the cited regulation was

promulgated, pursuant to T.D. 6377, 1959-1 C.B. 125, the Internal

Revenue Service’s published position with respect to paid

contested taxes was that such taxes are deductible in the year of
 - 29 -

payment, even though they continue to be contested. See G.C.M.

25298, 1947-2 C.B. 39, 44, which followed Chestnut Sec. Co. v.

United States, 104 Ct. Cl. 489, 62 F. Supp. 574 (1945).2 Under

those circumstances, the general accrual rule applicable to

contested taxes, contained in section 1.535-2(a)(1), Income Tax

Regs., could only have applied to unpaid taxes because its

extension to paid taxes would have been inconsistent with G.C.M.

25298. Since 1964, an extension of that provision to paid

contested taxes would be inconsistent with section 461(f), which,

in effect, codified and reinstated the Commissioner’s position in

G.C.M. 25298. Therefore, petitioner’s payment of the contested

taxes could serve only to accelerate a deduction to the year of

payment pursuant to section 461(f). There is no basis under

either the all events test or section 461(f) for the Court of

Appeals for the Fifth Circuit’s suggestion, J.H. Rutter Rex

Manufacturing Co. v. Commissioner, supra at 1297, that the

payment itself somehow justifies an accrual of such taxes in the

earlier year for which the taxpayer is subject to tax imposed by

section 531.

We are left, then, to determine whether the test of a

section 535(b)(1) tax accrual is the all events test.

2
Chestnut Sec. Co. v. United States, 104 Ct. Cl. 489, 62
F. Supp. 574 (1945), was effectively overruled by United States
v. Consol. Edison Co., 366 U.S. 380 (1961).
 - 30 -

III. Validity of Sec. 1.535-2(a)(1), Income Tax Regs.

The final sentence of section 1.535-2(a)(1), Income Tax

Regs., reads: “In computing the amount of taxes accrued, an

unpaid tax which is being contested is not considered accrued

until the contest is resolved.” That sentence leaves little

doubt that the Secretary of the Treasury intended the test of a

section 535(b)(1) tax accrual to be the all events test. See

Doug-Long, Inc. v. Commissioner, 73 T.C. at 81 (“The last

sentence of this regulation is consistent with the definition of

accrued taxes which has been set forth in Dixie Pine Products Co.

v. Commissioner, supra; Great Island Holding Corp. v.

Commissioner, * * * [5 T.C. 150, 160 (1945)]; and sec. 1.461-

2(b)(2), Income Tax Regs.”). The only question is whether that

is a valid interpretation of the statutory command of section

535(b)(1) that, in computing accumulated taxable income, taxable

income be adjusted by subtracting certain taxes “accrued” during

the taxable year. In Doug-Long, Inc. v. Commissioner, supra at

82, we held that the last sentence of section 1.535-2(a)(1),

Income Tax Regs., validly interprets the statute. In J.H. Rutter

Rex Manufacturing Co. v. Commissioner, supra at 1296, the Court

of Appeals for the Fifth Circuit made a cogent argument that the

accumulated earnings tax, a penalty tax, should not be based on

earnings “that may not exist at all depending on the deficiency

claimed.” Taken to its logical conclusion, the Court of Appeals’
 - 31 -

argument is an argument to read the term “[taxes] accrued during

the taxable year” in section 535(b)(1) as meaning “[taxes]

finally determined for the taxable year”.3 That is a rule that

Congress easily could have stated. Congress, however, used the

term “taxes accrued”, and the term “accrued” has a settled

meaning, incorporating the all events test, for Federal income

tax purposes. See, e.g., sec. 1.446-1(c)(1)(ii)(A), Income Tax

Regs. In Estate of Goodall v. Commissioner, 391 F.2d 775, 800

(8th Cir. 1968), vacating and remanding T.C. Memo. 1965-154, the

Court of Appeals for the Eighth Circuit gave precisely that

meaning to the term “accrued” in a predecessor version of section

535(b)(1). If section 535(b)(1) is not clear on its face, the

Secretary’s interpretation is permissible, since it defines a

term in a way that is reasonable in light of the legislature’s

revealed design. Chevron U.S.A., Inc. v. Natural Res. Def.

Council, Inc., 467 U.S. 837, 844 (1984).4 Although policy

3
That is, finally determined before the corporation’s
liability for accumulated earnings tax becomes final.
4
Petitioner suggests that the Chevron standard of review
should not apply because the accumulated earnings tax is in the
nature of a penalty. Even if we were to conclude that the final
sentence of sec. 1.535-2(a)(1), Income Tax Regs., is invalid on
that basis, it would not necessarily follow that petitioner would
be entitled to deduct from its 1995 accumulated taxable income
the amount of its 1995 Federal income tax deficiency as
determined by this Court. That is, if we were to invalidate the
final sentence of sec. 1.535-2(a)(1), Income Tax Regs., we would
still be required to interpret the meaning of the term “[taxes]
accrued during the taxable year” as used in sec. 535(b)(1). In
this regard, petitioner offers no support for the proposition
(continued...)
 - 32 -

considerations may suggest a taxes-as-finally-determined rule,

the use of a commonly understood term suggests the common

meaning, and the legislature’s design, as revealed, does not

contradict such usage.5

4
(...continued)
that Congress intended a taxes-as-finally-determined rule as
opposed to, say, a taxes-as-actually-reported rule.
5
The Court of Appeals for the Fifth Circuit in J.H. Rutter
Rex Manufacturing Co. v. Commissioner, 853 F.2d 1275, 1297-1298
(5th Cir. 1988), cites a line of cases beginning with Stern Bros.
Co. v. Commissioner, 16 T.C. 295 (1951), in support of its
position. Those cases uphold the accrual of contested taxes in
the year in which the contested tax liability arises when
computing accumulated earnings and profits for invested capital
purposes under the excess profits tax imposed in World War II.
Id. at 322-323. See also Estate of Stein v. Commissioner, 25
T.C. 940, 966 (1956), which extends the Stern Bros. Co. rationale
to permit the accrual of contested taxes in computing earnings
and profits for purposes of determining whether corporate
distributions are taxable dividends or nontaxable distributions
from capital. In Stern Bros. Co., we were interpreting a
regulation that required an accrual basis taxpayer to subtract
income and excess profit taxes “for the preceding taxable year”.
That is not necessarily the same as allowing a deduction for any
such taxes as are “accrued” during such preceding taxable year.
Moreover, Stern Bros. Co. and its progeny, including Estate of
Stein, specifically distinguish the computation of accumulated
earnings and profits from the computation of taxable income,
where Dixie Pine Prods. Co. v. Commissioner, 320 U.S. 516 (1944),
is acknowledged to be applicable. See, e.g., Stern Bros. Co. v.
Commissioner, supra at 322-323. The concept of taxable income is
not so different from that of “accumulated taxable income”, upon
which the accumulated earnings tax is imposed, as to make the
extension of Dixie Pine Prods. Co. to the latter an unreasonable
interpretation of the term “accrued” as it is used in sec.
535(b)(1).
 - 33 -

I conclude that section 1.535-2(a)(1), Income Tax Regs.,

validly interprets section 535(b)(1): The test of a section

535(b)(1) tax accrual is the all events test.

SWIFT, WHALEN, and MARVEL, JJ., agree with this concurring
opinion.