Here, Trinity’s delivery of each barge unconditionally fixed its right to receive the full contract price under the second contract. However, Trinity accrued only the payments received upon delivery and excluded the deferred payments. This was not appropriate.
Neither Flowers nor FMT ever disputed the fact or amount of its obligation to Trinity under the second contract. Their filings in the litigation expressly acknowledged their obligations and indicated they were “setting the withheld amounts aside in escrow or as collateral security” to offset whatever damages Trinity may ultimately be determined to owe them with respect to their claims under the first contracts. The court concluded that Trinity “effectively received” the withheld amounts when they were applied in compromise of Flowers’s and FMT’s claims. In the final analysis, the court found, the “offset claims” affected only the timing of Trinity’s receipt of income and not its right to receive the income.
Indeed, an accrual basis taxpayer must accrue income once the all-events test is satisfied. However, accrual might not be required if the income (the right to receive which has become fixed) is of “doubtful collectability.” Though in this case, the evidence did not show that Flowers or FMT was insolvent or bankrupt, or that the collectability of their debts was otherwise “called into question” by their financial conditions. Accordingly, the doubtful collectability exception to accrual of income was unavailable here.
Moreover, the court noted that Flowers and FMT asserted their claims of offset only after the barges were delivered and Trinity’s right to income had become fixed. Accordingly, postponement of accrual, in this case, is wholly unjustified.
Trinity had one last arrow in its quiver but its aim was found to be faulty; that is, Trinity contended that based on Section 461(f) of the tax code, it was entitled to deduct $4,520,000 in 2002 on the grounds that it transferred that amount to Flowers and FMT in satisfaction of their disputed claims for damages. Section 461(f) permits a taxpayer to deduct a “contested liability” provided the taxpayer has transferred amounts in the same taxable year to satisfy the contested liability.
Here, the $4,520,000 of deferred payments to which Trinity claimed a deduction came due in 2003 and 2004; Flowers and FMT, the court noted, cannot be said to have withheld the deferred payments before they came due. Further, Section 461(f) allows a deduction only for the taxable year of the transfer. Consequently, the court stated, “even if we were to agree that the withheld payments represented transfers we would conclude that the transfers occurred in 2003 and 2004.”
In any event, the court disagreed with Trinity’s contention that the withholding of the deferred payments represented a transfer. It observed that before a taxpayer may transfer money “beyond its control,” it must first have the money “within its control.” In this case, however, the deferred payments were never in Trinity’s control. Accordingly, no deduction under the authority of Section 461(f) was allowed to Trinity for its 2002 tax year. Thus, the disputed payments had to be accrued in 2002 and no offsetting deduction, available under the auspices of Section 461(f), could be claimed to offset this income.
Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.