Ninth Circuit: Taxpayer Can't Deduct Anticipated Expenses for Reconditioning Facilities

(Parker Tax Publishing January 2025)

The Ninth Circuit affirmed the Tax Court and held that a taxpayer's anticipated expenses for reconditioning its facilities failed to satisfy the "fact of liability" prong of the "all events" test in Code Sec. 461(h)(4) because the liability was not fixed, absolute, and unconditional. The court found that the taxpayer was making a mere estimate of liability for reconditioning costs based on its predicted future sales which, the court concluded, does not create a fixed liability under the all-events test. Morning Star Packing Company, L.P. v. Comm'r, 2024 PTC 450 (9th Cir. 2024).

Background

The Morning Star Packing Co., L.P. (TMSPC), a limited partnership, and Liberty Packing Co., LLC (LPC), a limited liability company, (collectively, Morning Star) provide bulk-packaged tomato products to food processors and customer-branded finished products to the food service and retail trades. It accounts for about 25 percent of the California processing tomato production, supplying 40 percent of the United States ingredient tomato paste and diced tomato markets.

When the fresh tomatoes arrive at a facility, they move from a truck into the facility through a tomato flume to sorting tables, choppers, and hot break tanks. At this point the product is in an airtight, closed, sterile environment. If there are any air leaks, dirt is sucked into the environment, which reactivates the germs and bacteria in the product, resulting in a loss of sterility that necessitates shutting down the production line.

Heat is a very important element in the evaporation process and the heat is provided by large natural gas boilers that produce high-pressure steam. The boilers are subject to stringent emission rules and regulations. Food processing facilities that are operated year-round are typically multiline facilities with built-in redundancies. If any one part of a processing line fails, the entire processing line must cease operation because of a loss of sterility. If a facility is not operable for more than a few hours during a season and the fresh tomatoes cannot be processed because of spoilage, Morning Star is obligated to pay the farmers the contract price for the tomatoes. Morning Star would also be liable for damages to its customers for failure to provide the promised tomato paste. The resulting payments for the farmer's and customer's damages could be catastrophic for Morning Star.

Morning Star's customers generally require that the tomato products produced meet certain quality and sanitary specifications. Many of its customers require independent testing to assure sterility and quality. Because Morning Star contracts to supply tomato paste to the U.S. Department of Agriculture (USDA), its facilities must pass USDA inspections for safety, sterility, and quality. The U.S. Food and Drug Administration and the State of California Department of Public Health also inspect the facilities.

During years 2008-2011, Morning Star entered into several credit financing agreements under which it agreed to, among other things to: (1) maintain all material licenses, permits, governmental approvals, rights, privileges and franchises reasonably necessary for the conduct of its business; (2) conduct its business activities in compliance with all laws and material contractual obligations applicable to such person, and (3) keep all property useful and necessary in its business in good working order and condition, ordinary wear and tear excepted.

For those years, Morning Star increased its costs of goods sold (COGS) for the costs to restore, rebuild, recondition, and retest their manufacturing facilities for use during the next production cycle. It maintains reserves that it refers to as "production accrual" (production accrual reserve accounts). These reserves are used to account for future costs associated with restoring, rebuilding, and retesting the manufacturing facilities for use during the next production cycle. The production accrual reserve accounts include amounts for production labor, boiler fuel, electricity, waste disposal, chemicals and lubrication, production supplies, repairs and maintenance, lease, production wages, and administration wages. The accrued production costs are recurring, and Morning Star determines the amounts to be set aside in the reserves to cover these costs with reasonable accuracy. Economic performance of the production accrual liabilities does not occur until the next tax year.

For the years at issue, the IRS determined that Morning Star was not entitled to increase its COGS for the amount of accrued production costs because: (1) Morning Star had not shown that, pursuant to Code Sec. 461, all events had occurred to establish the fact of the liabilities, and (2) economic performance had not occurred with respect to the liabilities to qualify for accrual. Specifically, the IRS argued that the accrued production costs that Morning Star included in COGS for the years in issue were: (1) not fixed and binding until the following tax year when it began economic performance, and (2) more properly matched against income for the tax year in which economic performance occurred under the Code Sec. 461(h)(3) recurring items exception to the all events test.

Generally, an accrual method taxpayer may deduct expenses for the years in which the taxpayer incurred the expenses, regardless of the actual payment dates. The all events test in Code Sec. 461(h)(4) and Reg. Sec. 1.461-1(a)(2) governs whether a business expense has been incurred to permit its accrual for tax purposes. Liability is incurred under the all events test if three factors are met: (1) all of the events that establish the fact of the liability must have occurred, (2) the amount must be able to be determined with reasonable accuracy, and (3) economic performance must have occurred.

While the IRS conceded that Morning Star determined its accrued production costs with reasonable accuracy and complied with the economic performance requirement, it also argued that the accrued production costs consisted of bilateral contracts for goods and services to recondition the manufacturing facilities that were provided to and paid for by Morning Star after the December 31 close of their tax year. Thus, the IRS contended that all events had not occurred during the years in issue to establish the fact of the liabilities for the accrued production costs.

Morning Star disagreed and took its case to the Tax Court, arguing that the IRS's focus on the bilateral goods and services contracts was misplaced. Instead, Morning Star countered, the credit agreements and multiyear contracts to supply customers with tomato products obligated them to incur the accrued production costs to restore, rebuild, and retest the manufacturing facilities.

In T.C. Memo. 2020-142, the Tax Court held that Morning Star could not increase its COGS for the amount of accrued production costs because (1) it had not shown that all events had occurred to establish the fact of the liabilities, and (2) economic performance had not occurred with respect to the liabilities. The court also rejected Morning Star's assertion that multi-year production contracts with various customers established the fact of its liabilities because, the court found, Morning Star's efforts to comply with its customers' specifications were production-run specific and the accrued production costs in issue were for goods and services provided after the production runs.

Morning Star appealed to the Ninth Circuit. Citing its financing agreements, Morning Star argued that the final production run of the harvest season fixes a liability to recondition its facilities. According to Morning Star, the fact that its facilities require between $16.7 million and $21 million in reconditioning costs to restore the facilities to the same operating capability as before the start of production, meant that the equipment must be "in a state of disrepair beyond mere 'ordinary wear and tear.'" Morning Star also argued that its contracts with customers suggested that it has a fixed liability for reconditioning as a result of its commitments to customers to provide a high degree of certainty that the reconditioning costs would in fact be completed.

Analysis

The Ninth Circuit affirmed the Tax Court and held that Morning Star could not increase its COGS for accrued production costs. The court found that Morning Star was making "a mere estimate of liability" based on its predicted future sales, which, the court said, does not create a fixed liability under the all events test.

With respect to Morning Star's argument concerning the amount it must spend on reconditioning its facilities, the court said that the mere total of Morning Star's reconditioning costs does not suggest that its equipment is in disrepair beyond ordinary war and tear.

With respect to its argument that its contracts with customers suggest that it has a fixed liability for reconditioning, the court said that providing its customers with a high degree of certainty that something will be done is not the same as a certain obligation to do something.

Observation: In a dissenting opinion, Judge Bumatay observed that the IRS had endorsed Morning Star's procedures in an audit of the company in the early 1990s. He found it disturbing that after following this practice for all these years, the IRS has changed its mind and is now demanding that Morning Star alter how it recognizes its reconditioning costs. He cited two cases, U.S. v. Hughes Properties, Inc., 476 U.S. 593 (1986), and Gold Coast Hotel & Casino v. U.S., 158 F.3d 484 (9th Cir. 1998), that support Morning Star's position that it is entitled to use the accrual method of accounting to deduct expenses in the year which they are incurred, regardless of when paid.

For a discussion of the correct year for deducting an expense and the all-events test requirements, see Parker Tax ¶241,740.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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