When You Can’t Deduct Annual Business Expenses – Houston Tax Attorneys

Many businesses have significant recurring expenses that occur like clockwork each year. Think of annual maintenance shutdowns for manufacturing plants, seasonal refurbishments for hotels, or equipment rebuilds for industrial operations. While these expenses are predictable and virtually certain to occur, the timing of when they can be deducted for tax purposes isn’t always straightforward. The recent Morning Star Packing Co. v. Commissioner, No. 21-71191 (9th Cir. 2024), case provides an opportunity to consider when these expenses can be deducted.

Facts & Procedural History

The taxpayer in this case operates one of the largest tomato processing operations in the United States. During its 100-day processing season, the company runs its equipment at the maximum capacity, running 24-hours a day. This intensive operation requires extensive reconditioning of the equipment after each season. The historical cost has been between $16.7 and $21 million annually leading up to the year at issue in this case.

The taxpayer is an accrual method taxpayer. The taxpayer has always deducted these reconditioning costs on its income tax returns in the tax year when the wear and tear occurred–at the end of each processing season. Even though the costs were expected and known, the actual reconditioning work is performed just before the start of the next season.

The IRS had previously audited the taxpayer and accepted this method. Then, years later, the IRS conducted another audit and challenged the use of this method. The IRS argued that the expenses couldn’t be deducted until the work was actually performed. The U.S. Tax Court agreed with the IRS, which resulted in this appeal.

Why Does This Type of Timing Issue Matter?

Before getting into the rules, it is helpful to pause to consider why this type of timing issue matters.

At first glance, this might seem like something that is not all that important. After all, the taxpayer will eventually get to deduct these expenses–it’s just a question of which tax year. But timing can have significant financial implications.

Unlike government agencies like the IRS, businesses have to answer to a number of third parties. This includes investors, lenders, landlords, and others and for smaller businesses, the business’ owners. The timing of large deductions can impact the interaction with these third parties. There are two extremes here. There are instances where a business may want a level tax liability each year. There are other instances where the business wants to time expenses so that the tax liability fluctuates. For the former, an unexpected cash-tax liability can impact operations given that taxes are often one of a business’ largest annual expenses. For the latter, the tax windfall in the low tax year may be cash that is needed to be used for capital improvements or expansion.

Underlying this is also the concept of time value of money. Taxpayers may simply prefer to get a deduction sooner rather than later. Getting a $21 million tax deduction a year earlier has real economic value due to the time value of money. Even at a modest 5% interest rate, the difference in present value is substantial.

There is also planning for tax rate changes. Tax rates may vary between years, either due to legislative changes or a taxpayer’s changing circumstances. Deducting expenses in higher-rate years can be more valuable. The same goes for loss years. The timing of large deductions can affect whether a business shows a loss in particular years, which has implications for loss carrybacks and carryforwards that can free up cash.

As you can see, this is one of the tools the tax planner has to work with to help a business achieve its financial goals.

About the Accrual Method

The timing of expense deductions depends largely on whether a taxpayer uses the cash or accrual method of accounting. The accrual method is required for many larger businesses–businesses that are large or businesses that have inventory. The accural method aims to match income and expenses to the period when they are earned or incurred–regardless of when cash changes hands. It can also be used to defer paying taxes in some cases. This differs from the cash method, where expenses are simply deducted when paid.

While the cash method is simpler, it can distort the true financial picture when large expenses are paid in different periods than the related income is received. Cash-basis businesses know this well. Cash-basis business owners or managers may feel that they are doing well financially, only to realize that they failed to account for an accrued liability that they will have to pay all at once. During this window, the business owner or manager may spend money they have on hand under the mistaken belief that they have it available to spend. This can result in default on legal obligations and, often, the business going out of business.

The “All Events” Test

This brings us to the “all events” test. The “all events” test is the name of the game when it comes to the accrual method. This test has two main requirements for liabilities:

All events must have occurred that establish the fact of liability

The amount must be determinable with reasonable accuracy

The Morning Star case focused on the first requirement–whether the fact of liability was established when the processing season ended, even though the work hadn’t been performed yet.

The “Fact of Liability” Prong

So what is the “fact of liability?” A liability is considered “fixed” when it is legally established and unconditional. The courts have established that a liability must be ‘fixed, absolute, and unconditional’ to satisfy this requirement. The liability cannot be contingent on some future event.

For example, if a business agrees to pay a bonus if certain targets are met, the liability isn’t fixed until those targets are actually met. However, once a liability is legally binding, the fact that payment will be made in the future doesn’t prevent it from being “fixed” for tax purposes.

That brings us to this case. The taxpayer in this case argued that the final production run of the season created a fixed liability because:

The amount was known based on historical costs

The loan agreements required maintaining the equipment in good working order

The customer contracts required continued production capabilities

The equipment could not be used again without reconditioning

The taxpayer essentially argued that these combined obligations created a legal duty to recondition the equipment once the season ended.

The majority of the judges in this case held that the taxpayer’s reconditioning expenses weren’t fixed at the end of the tomato season. This was largely because they did not accept the taxpayer’s arguments about its financing agreements. The court noted that because the financing agreements only required maintaining equipment in “good condition and repair, reasonable wear and tear excepted,” that is all these expenses were. The majority found these expenses to be repair costs for ordinary wear and tear that could be done at any time–not necessarily annually.

What is “Fixed” for an Annual Recurring Expense?

The dissent made several compelling arguments in this case for when an annual recurring expense like this is actually “fixed.”

The dissent argued that $21 million in damage could not possibly constitute “reasonable wear and tear.” As Judge Bumatay noted, “Ordinary wear and tear is when your bathroom’s tiles fade… It is not catastrophic damage that requires millions to repair.” The dissent also pointed out that the company’s lenders would hardly allow $21 million in unaddressed damage to their collateral. When combined with customer contracts requiring continued production, this created a fixed obligation to perform the reconditioning.

The dissent also noted that the court’s decision is at odds with other cases involving fixed liabilities. For example, the dissent cited United States v. Hughes Properties in which the Supreme Court allowed a casino to deduct guaranteed slot machine jackpots before they were won. The Court in that case focused on the fact that state law made the liability fixed and determinable. Similarly, in Gold Coast Hotel, deductions were allowed for slot club points when members accumulated enough points to qualify for prizes, even though the prizes hadn’t been claimed yet. There are also court cases that reach the same result for gift cards. These cases suggest that a liability can be “fixed” even when payment or performance occurs later.

The Takeaway

This case highlights how difficult it is to determine when an expense is really fixed. This issue is ultimately a timing issue. A little tax planning can still achieve the desired timing. Businesses with large recurring expenses should review their contracts and consider whether modifications could help establish the “fact of liability” earlier in their business cycle. These taxpayers may need to restructure their contracts to explicitly create the liability, at least on paper, for the desired tax year. This case shows exactly how the taxpayer might do that.