Opinion ID: 368059
Heading Depth: 1
Heading Rank: 1

Heading: deductions for accrued unpaid compensation.

Text: 9 The facts relevant to this appeal by taxpayers were found by the Tax Court as follows: 10 At a meeting of Putoma's directors held in July, 1964, Purselley's 2 salary was set at $600 per month, retroactive from July 1, 1963. This salary was not to be paid, but was to accrue to his credit until such time as, in the judgment of the majority of directors, corporate earnings were sufficient to justify payment of the salary. In addition, as part of his compensation, Purselley was to receive 25 percent of the corporation's net profits. Compensation from July 1, 1964, was to be determined at a future meeting. 11 The minutes of the board of directors' meeting for Putoma held on August 23, 1965, contain the following statement relating to salary: 12 Upon motion duly made and seconded, the salary of Lee Roy Purselley for the current year was fixed at $2,000.00 per month plus 25% Of the net profit of the corporation after deduction of the $2,000.00 monthly salary, but before deduction for any bonus or Federal income taxes. This salary is to be retroactive from July 1, 1965. Such salary in excess of the $2,000.00 per month is not to be paid but to accrue to his credit until such time as in the judgment of the majority of the directors of the company, the company has such cash reserve in order to pay the additional salary. 13 Upon further motion duly made and seconded, the salary of J. M. Hunt was established at 10% Of the net income of the company before the deduction of any bonus or Federal income taxes. This salary is to be retroactive from July 1, 1965. Such salary is not to be paid, but to accrue to his credit until such time as in the judgment of the majority of the directors of the company, the company has sufficient cash reserve in order to pay the salary. 14 The compensation formula set out above remained unchanged until January 1, 1970. At a meeting of Putoma's directors held on December 10, 1969, bonuses for Purselley and Hunt were discontinued as of December 31, 1969, and Purselley's salary was set at $3,000 per month beginning January 1, 1970. 15 The following schedule shows salary and bonus accruals, and cash payments for Purselley and Hunt recorded on Putoma's books for fiscal years ended June 30, 1964, through calendar year December 31, 1971: 16 LEE ROY PURSELLEY ----------------- RECORDED ON BOOKS ----------------- CASH PERIOD ENDED YEARLY SALARY YEARLY BONUS PAYMENTS ------------ ------------- ----------------- ----------- 6/30/64 $ 7,200 $ 2,763.64 $ -- 6/30/65 7,200 2,791.59 10,335.94 6/30/66 24,000 21,408.42 11,210.00 6/30/67 24,000 45,115.41 29,909.32 6/30/68 24,000 85,324.03 38,004.57 6/30/69 24,000 43,833.66 3 33,269.86 6/30/70 30,000 -- 25,480.44 12/30/70 18,000 -- 14,000.00 12/31/71 -- -- 15,473.75 ------------- ----------------- ----------- $158,400 $201,236.75 $177,683.88 J. M. HUNT ---------- 6/30/64 $ -- $ -- $ -- 6/30/65 -- -- -- 6/30/66 -- 8,563.87 -- 6/30/67 -- 6,711.92 -- 6/30/68 -- 34,129.61 -- 6/30/69 -- 17,533.46 -- 6/30/70 -- -- -- 12/31/70 -- -- -- 12/31/71 -- -- -- ------------- ----------------- ----------- $ -- $66,938.86 $ -- 17 Pro-Mac was formed on December 1, 1966. Article V, Section 4 of Pro-Mac's by-laws provides that the salaries of corporate officers are to be fixed by the board of directors. The minutes of the organizational meeting of Pro-Mac's board of directors, however, contain no mention of officer compensation. Further, there were no board of directors' minutes for Pro-Mac during the period November 30, 1966, through July 18, 1969. Nevertheless, Pro-Mac's books and records for that period reflect that the corporation consistently recorded a salary expense of $1,000 per month for both Hunt and Purselley, and further recorded a bonus expense equal to 25 percent of profits for Purselley and bonus expense equal to 10 percent of profits for Hunt. The Tax Court found, however, that the salaries and bonuses for Purselley and Hunt recorded by Pro-Mac on its books were not payable until Pro-Mac's earnings were sufficient to permit payment. 18 The first minutes to discuss compensation for Pro-Mac's officers were those of a directors' meeting held December 10, 1969. At that time, it was decided to discontinue the bonuses for Purselley and Hunt and to fix Purselley's salary at $3,000 per month commencing January 1, 1970. At a subsequent meeting held August 27, 1970, a $1,000 per month salary was also voted for Hunt, retroactive to January 1, 1970. Due to the low cash condition of the corporation, Hunt's salary was to be recorded in his accrued salary account, but was not to be paid until a later date when the corporation was financially able. 19 The following schedule shows when salary and bonus amounts and cash payments for Purselley and Hunt were recorded on Pro-Mac's books for fiscal years ended July 31, 1967, through August 31, 1971 (R. 104): 20 LEE ROY PURSELLEY ----------------- RECORDED ON BOOKS ----------------- CASH PERIOD ENDED YEARLY SALARY YEARLY BONUS PAYMENTS ------------ ------------- ------------ ---------- 7/31/67 $ 8,000 $ 9,366.11 $ -- 7/31/68 12,000 27,466.04 -- 7/31/69 12,000 14,575.63 30,097.54 7/31/70 12,000 4,753.85 -- 7/31/71 -- -- -- 8/31/71 -- -- -- ------------- ------------ ---------- $49,000 $56,161.68 $30,097.54 J. M. HUNT ---------- 7/31/67 $ 8,000 $ 3,746.44 $ -- 7/31/68 12,000 10,986.41 -- 7/31/69 12,000 5,830.25 30,097.54 7/31/70 12,000 1,208.20 -- 7/31/71 5,000 -- -- 8/31/71 -- -- -- ------------- ------------ ---------- $44,000 $21,771.30 $30,097.54 21 At a meeting of Putoma's board of directors on July 9, 1970, a discussion was held concerning the current financial condition of the corporation. It was agreed that in order to reflect a better financial condition to creditors and potential lenders, Hunt and Purselley would be asked to forgive a portion of the salaries shown owing to them on the books. Substantially the same decision was made by Pro-Mac's board of directors in a meeting held the same day. 22 On September 15, 1970, Purselley and Hunt forgave the following items shown owing to them on the books and records of Putoma and Pro-Mac: 23 PUTOMA PRO-MAC ----------- ---------- Lee Roy Purselley accrued salary $ 89,109.06 $44,453.50 Hunt accrued salary 66,938.36 35,673.76 Hunt accrued interest 22,170.70 2,779.74 Hunt accrued commission - 6,000.00 ----------- ---------- Total $178,218.12 $88,907.00 24 On September 15, 1970, Purselley's accrued payroll account on Putoma's books showed a balance of $194,626.32, before forgiveness, and $106,017.26 after forgiveness. Hunt's accrued payroll account on Putoma's books and records showed a balance of $66,938.36 before forgiveness and $0 after forgiveness. 25 On September 15, 1970, Purselley's accrued payroll balance on Pro-Mac's books showed a balance of $72,064.09 before forgiveness and $27,610.59 after forgiveness. Hunt's accrued payroll account on Pro-Mac's books showed a balance of $37,673.76 before forgiveness and $2,000 after forgiveness. 26 On their returns for the years in issue, the taxpayer corporations claimed deductions for the salaries and bonuses for Purselley and Hunt which they had accrued on their corporate books. The Commissioner disallowed the deductions to the extent they represented accrued but unpaid salaries on the ground that taxpayers' liability for the accrued salaries and bonuses was contingent and not fixed during the years in question. 4 The Tax Court, in a reviewed opinion with no dissents as to this issue, sustained the Commissioner's determination. 27 Ever since the Supreme Court rendered its opinion in United States v. Anderson, 269 U.S. 422, 46 S.Ct. 131, 70 L.Ed. 347 (1926), it has been the rule that accrual taxpayers, such as Putoma and Pro-Mac in the instant case, may deduct an expense in the taxable year in which all the events have occurred which determine the fact of liability and which fix with reasonable certainty the amount of such liability. In that case the court said: 28 Only a word need be said with reference to the contention that the tax upon munitions manufactured and sold in 1916 did not accrue until 1917. In a technical legal sense it may be argued that a tax does not accrue until it has been assessed and becomes due; but it is also true that in advance of the assessment of a tax, all the events may occur which fix the amount of the tax and determine the liability of the taxpayer to pay it. In this respect, for purposes of accounting and of ascertaining true income for a given accounting period, the munitions tax here in question did not stand on any different footing than other accrued expenses appearing on appellee's books. In the economic and bookkeeping sense with which the statute and Treasury decision were concerned, the taxes had accrued. 269 U.S. 440-441, 46 S.Ct. 134. 29 The all events test has been applied many times by various courts since the decision in Anderson was handed down. See Brown v. Helvering, 291 U.S. 193, 54 S.Ct. 356, 78 L.Ed. 725 (1934); Dixie Pine Products Co. v. Commissioner, 320 U.S. 516, 64 S.Ct. 364, 88 L.Ed. 270 (1944); Trinity Construction Co. v. United States, 424 F.2d 302 (5 Cir. 1970); Guardian Investment Corp. v. Phinney, 253 F.2d 326 (5 Cir. 1958); United States v. Consolidated Edison Co., 366 U.S. 380, 385, n. 5, 81 S.Ct. 1326, 6 L.Ed.2d 356 (1961); Clevite Corp. v. United States, 386 F.2d 841, 843, 181 Ct.Cl. 652, 658 (1967); Denver & Rio Grande Western Railroad Co. v. Commissioner, 38 T.C. 557, 572 (1962); Turtle Wax, Inc. v. Commissioner, 43 T.C. 460, 466-67 (1965); Union Pacific R. R. Co. v. United States, 524 F.2d 1343, 208 Ct.Cl. 1 (1975); and Koehring Co. v. United States, 421 F.2d 715, 190 Ct.Cl. 898, 905 (1970). In fact, the test is now included in the Treasury Regulations as follows: 30 Under an accrual method of accounting, an expense is deductible for the taxable year in which all the events have occurred which determine the fact of the liability and the amount thereof can be determined with reasonable accuracy. Treas.Reg. § 1.461-1(a)(2) (1970), promulgated by T.D. 6282, 1958-1 Cum.Bull. 215, 22 F.R. 10686, Dec. 25, 1957, 26 C.F.R. § 1.461-1(a)(2) (1970). 31 Stated conversely, the accrual of an item of expense is improper where the liability for such item in the taxable year is contingent upon the occurrence of future events. Security Flour Mills Co. v. Commissioner, 321 U.S. 281, 64 S.Ct. 596, 88 L.Ed. 725 (1944); Brown v. Helvering, supra. The Supreme Court stated in Brown, supra : 32 Except as otherwise specifically provided by statute, a liability does not accrue as long as it remains contingent    . 291 U.S. 200, 54 S.Ct. 360. 33 This court held in Guardian Investment Corporation v. Phinney, supra : 34 A contingent obligation may be a liability, but it is not a debt: and accrual is improper for tax deductions when the liability is contingent. 253 F.2d 329. 35 The Court of Claims held in Union Pacific R. R. Co. v. United States, supra : 36 So long as a liability remains contingent or if the liability has attached but the amount cannot be reasonably estimated, a business expense deduction is not allowed. 524 F.2d 1350, 208 Ct.Cl. 18. 37 The foregoing authorities show that without dispute the all-events test is incorporated in the law. The only question to be answered in this case is whether or not the test has been met. Putoma and Pro-Mac contend that the accrued salaries and bonuses were definite fixed obligations that were mathematically arrived at under an authorized and definite formula, and that only the payment was deferred. They argue that under these facts the all-events test has been complied with. We do not agree. 38 The minutes of Putoma's Board of Directors' meeting held on August 23, 1965, quoted above, show that the Board set Purselley's salary at $2,000 per month month plus a bonus of 25% Of the net profit of the corporation. However, the payment of the bonus was made conditional on the financial condition of the corporation by the following minutes: 39 Such salary in excess of the $2,000 per month is not to be paid but to accrue to his credit until such time as in the judgment of the majority of the directors of the company, the company has such cash reserve in order to pay the additional salary. 40 As a part of the same minutes, the Board set Hunt's salary at 10% Of the net income of the corporation which was not to be paid, like Purselley's bonus, until such time as in the judgment of the directors, the corporation had sufficient cash reserve in order to pay the salary. In this regard, the minutes provided: 41 Upon further motion duly made and seconded, the salary of J. M. Hunt was established at 10% Of the net income of the company before the deduction of any bonus or Federal income taxes. This salary is to be retroactive from July 1, 1965. Such salary is not to be paid, but to accrue to his credit until such time as in the judgment of the majority of the directors of the company, the company has sufficient cash reserve in order to pay the salary. 42 The compensation formula set out above remained unchanged until January 1, 1970. At a meeting of Putoma's directors held on December 10, 1969, bonuses for Purselley and Hunt were discontinued as of December 31, 1969, and Purselley's salary was set at $3,000 per month beginning January 1, 1970. 43 It is clear from these minutes of the Board that Putoma had no fixed obligation during the years involved to pay Hunt's salary or Purselley's bonus. Such obligation was not to come into being until sometime in the future when the directors determined that the corporation had sufficient cash reserve to make the payments. 44 Pro-Mac had a similar arrangement. Its books showed that Purselley was entitled to a bonus of 25% Of the company's profits and that Hunt was entitled to a bonus of 10% Of the profits of the company. The Tax Court found that Pro-Mac's liability for these salaries and bonuses, like those of Putoma, were contingent on the financial condition of the company. 5 45 We conclude that the obligation of Putoma and Pro-Mac to pay the salaries was not a fixed obligation but was contingent and conditioned on future events, namely, the financial condition of the corporations and the determination of the same by their Boards of Directors. In addition to the authorities cited above that prohibit the deduction of contingent and conditional obligations, see this court's decision in Burlington-Rock Island Railroad Co. v. United States, 321 F.2d 817 (5 Cir. 1963), Cert. denied, 377 U.S. 943, 84 S.Ct. 1349, 12 L.Ed.2d 306 (1964). In that case, the taxpayer sought to deduct accrued but unpaid interest on its debt to its shareholder-creditors. Under the terms of an agreement entered into with its creditors, the taxpayer was required to make the interest payments from time to time, insofar as its cash situation will reasonably permit. In disallowing the claimed interest deductions, this Court pointed out that the agreement created only a conditional obligation to pay the interest and that the creditors could enforce payment only by showing that taxpayer had sufficient funds for that purpose. The court then went on to conclude: 46 Burlington's (taxpayer's) duty to pay the statutory interest was thus contingent upon its financial situation, and no legal obligation could arise under the agreement until the occurrence of that contingency. 321 F.2d 821. 47 Also, see Pierce Estates v. Commissioner, 195 F.2d 475 (3 Cir. 1952). There, the taxpayer was obligated to pay annual interest at a fixed rate but only from its net income as ascertained and declared by its board of directors. The court held that the taxpayer had correctly deducted the interest in the year of payment rather than accruing and deducting the interest each year because its legal duty to pay the interest was contingent on the actions of its directors. In so holding, the court stated: 48 Because interest is compensation for the use or forbearance of money it ordinarily accrues as an item of expense from day to day even though its payment may be deferred until a latter date. But this is not true if the payment is not merely deferred but the obligation to pay at all is wholly contingent upon the happening of a later event as, for example, the subsequent earning of profits. In the latter case, the interest may not be regarded as an accrued expense until the year in which, by the earnings of the profits the contingency is satisfied and the obligation to pay becomes fixed and absolute. 6 195 F.2d 477. 49 We hold that the all-events test was not met as to salaries and bonuses of Purselley and Hunt and that the deductions of such items were improperly made by Putoma and Pro-Mac. 7 50