Source: http://www.irs.gov/Businesses/Corporations/Industry-Director-Directive-on-IRC-Section-172(f)-Specified-Liability-Losses---Attachment-1
Timestamp: 2013-06-19 21:18:32
Document Index: 649676477

Matched Legal Cases: ['§172', '§172', '§1', '§172', '§6110', '§172', '§172', '§1', '§1', '§6110', '§1033', '§1033', '§6110']

Industry Director Directive on IRC Section 172(f) Specified Liability Losses - Attachment 1
Issue Name: Product Liability
IRC §172(f)(2) limits the amount of the specified liability loss to the amount of the NOL for the year. To the extent the NOL exceeds the specified liability loss; any excess is then carried back 2 years following the regular NOL carryback rules
Product liability losses do not include injuries to employees while manufacturing the product, or injuries or damages sustained while delivering, installing or testing the product for the customer. Product liability losses do not include normal costs of repairs and maintenance or warranty items or liabilities incurred as a result of services performed by the taxpayer. ▲ Caution!
Note that while the statute expressly includes expenses incurred in investigating, settling, and opposing claims in defining product liability losses, it does not repeat these expenses in the definitions of the other five permitted categories of specified liability losses listed in IRC §172(f)(1)(B).
Congress first enlarged the carryback period for NOLs attributable to product liability (product liability losses) in the Revenue Act of 1978. This enactment constituted part of a congressional response to a perceived business crisis arising from product liability claims, including an inability to obtain product liability insurance at reasonable prices. Congress provided a larger carryback period for product liability losses because product liabilities tend to be large and sporadic. The expanded carryback period reduces the likelihood that a large product liability loss will exceed taxable income during the carryback period. Staff of the Joint Committee on Taxation, 95th Cong., General Explanation of the Revenue Act of 1978 232 (Comm. Print 1979). Taxpayers receiving tax refunds attributable to the larger carryback period could also use those funds to pay product liability claims. 124 Cong. Rec. 34,733 (1978).
The definition of what constitutes a product liability varies among the states and has changed over time. Regulation §1.172-13(b)(2)(iii) clarifies that the federal tax definition of product liability controls rather than state law when it comes to IRC §172(f). TAM 2003410041 involved a taxpayer’s claim of product liability treatment for defective fasteners it manufactured. The amounts included both cash payments to customers and accounts receivable write-offs. The taxpayer could not trace the manufacturing deficiencies to particular production lots and thus had to test and repair (rework) a substantial quantity of fasteners. Some of the taxpayer’s customers stopped paying for items already shipped to them claiming that testing and other costs exceeded any amount they owed the taxpayer. Some customers asserted claims for additional inventory carrying costs since they could not sell these defective fasteners. Other customers claimed “cover” charges since they had to find a replacement supplier for the fasteners at a higher than contracted for cost. The damages at issue did not involve actual personal injury or physical property damage. The TAM provides considerable discussion about how product liability is defined for tax purposes and concludes that the taxpayer’s damages do not qualify for the 10-year carryback.
1 Technical Advice Memorandum (TAM) 143949-01, TAM 200341004 (Oct. 10, 2003), discusses the manner in which product liability is defined for tax purposes. Do not cite this TAM as precedent per IRC §6110(k)(3), as the disclaimer at the end of this memorandum directs. See, e.g., IRM 4.43.1.4.18.1(3).
Specified liability losses for the 5 items specifically enumerated in IRC §172(f)(1)(B)(i) only include amounts “in satisfaction of” the otherwise qualifying liability. Product liability losses, by definition under IRC §172(f)(1)(A)(ii), also include the expenses incurred to investigate, settle or oppose product liability claims against the taxpayer. This is not an unlimited license however to include all items, no matter how remotely connected. Regulation §1.172-13(b)(1)(ii)(B) provides “Indirect corporate expense, or overhead, is not to be allocated to product liability claims so as to become a product liability loss.”
Regulation §1.172-13(b)(3) Example (2) illustrates this point. If the manufacturer of heating equipment sells a boiler to a customer and the boiler explodes after it has
been installed and turned over to the customer, while the cost of damage or injury caused by the boiler qualifies as a product liability loss, the cost to replace or repair the boiler does not.
The District Court looked to Black’s Law Dictionary 963 (8th ed. 2004) for the definition of “loss”: “failure to maintain possession of a thing”. The court stated “There is no dispute that the intended use of the lock-nuts was inventory for resale by Harvard’s customers. It follows that the loss of such use, under the definition of loss cited above, could not have occurred. Loss contemplates possession followed by the failure to maintain possession. Harvard’s customers did not have possession of lock-nuts fit for resale at any point; they merely had possession of defective lock-nuts that were unfit for resale. Consequently, Harvard's customers could not have lost the use of the property for its intended purpose where they did not possess usable lock-nuts in the first place.”
The District Court also addressed the requirement that the taxpayer must have relinquished possession of the product. “In the instant case, the defect that gave rise to Harvard's liability arose during the manufacturing of the lock-nuts, as Harvard's own brief admits. (Appellee's Br. at 5). Since the damage to the property clearly occurred before Harvard relinquished possession of the product, the damage to the lock-nuts is excepted from the statutory definition of product liability as stated in 26 U.S.C. section 172(f)(4).”
Examiners should review any claims for damages resulting injury, harm, or damage due to defective products to ensure that the taxpayer had completed all the necessary steps to deliver, install, initially service and test the equipment and relinquish control to the customer before the defective product malfunctioned. For large projects this may involve inspecting all the contracts and any necessary sign-offs on building or other permits. Details can also be found in the court documents or complaints filed against the taxpayer alleging liability for damages.
This is an area where we have encountered significant differences in treatment by taxpayers. Some taxpayers have failed to report the insurance reimbursements, either on an as received basis or by accrual even though the taxpayer has a reasonable prospect of recovery. These taxpayers have instead deducted the expense payments and treated them as eligible for a 10-year carryback. See FSA 1992 WL 13548252 which concluded, based upon its facts, that even though a contested liability is paid, a deduction may not be accrued “because under these facts a right to reimbursement existed which was virtually certain to be paid. Such a right to reimbursement precludes a section 162 trade or business deduction.”
2 Field Service Advisory Memorandum (FSA) 1027A, 1992 WL 1354825 (1992), discusses the applicable law and potential taxpayer positions regarding this issue. Do not cite this FSA as precedent per IRC §6110(k)(3), as the disclaimer at the end of this memorandum directs.
One taxpayer, in the environmental remediation area, contended that insurance settlement payments received under third-party Commercial General Liability policies were monies received due to an involuntary conversion under IRC §1033(a)(2). TAM 2003220173 concluded that insurance settlement payments received by the taxpayer in this scenario were monies received for indemnification with respect to tort liability and not monies received due to an involuntary conversion.
3 TAM 200322017 (Feb. 13, 2003), discusses the applicable law surrounding the treatment of insurance settlement payments and the nonapplicability of IRC §1033. Do not cite this TAM as precedent per IRC §6110(k)(3), as the disclaimer at the end of this memorandum directs.