28 Tax Notes 920

Tax Notes

AUGUST 19, 1985

LENGTH: 1180 words

DEPARTMENT: Current and Quotable (CQT)

CITE: 28 Tax Notes 920

HEADLINE: 28 Tax Notes 920 - JOHNSON URGES TIGHTENING REGULATIONS UNDER SECTION 404(a)(5). (Doc 85-6999)

AUTHOR: Johnson, Calvin H.

University of Texas

TEXT:

Set forth below is the full text of a July 2 letter from University of Texas law professor Calvin H. Johnson to David Brockway, chief of staff of the Joint Committee on Taxation, urging the repeal of the 'deferred' requirement in section 404(a)(5) of the Code. According to Johnson, the definition of the term 'deferred' permits the current deduction of items that have not been paid, resulting in tax 'floats' that make it profitable for employers to incur liabilities. The full text of Johnson's letter has also been placed in the August 5, 1985 Tax Notes Microfiche Data Base as Doc 85-6999.

Dear Mr. Brockway:

As a part of the current legislation, Congress needs to tighten up or repeal the requirement that compensation be 'deferred' for 'payee matching' to apply. Section 404(a)(5) of the Code requires an accrual method taxpayer to defer its deduction for deferred compensation until the recipient includes the item in income ('payee matching'). The purpose of the requirement is 'to prevent the allowance of a deduction without the corresponding inclusions in income.'/1/ Without payee matching, the parties could construct and share the value of a tax asset, a tax float at the expense of the government, by deducting a liability long before it is paid or taxed on the other side. The Tax Reform Act of 1984 expanded section 404(a)(5) so that, for example, a 'limited partnership that uses the accrual method of accounting may not accrue deductions for compensation owed to cash-method taxpayers, who perform services for the partnership, until the partnership taxable year in which such compensation is paid.'/2/

Section 404(a)(5) applies, however, only to deferred benefits./3/ Unfortunately, the definition of 'deferred' appears to be so vague or so loose that it tolerates serious abuses of the tax system. Under prior law a benefit was 'direct,' not 'deferred,' if it was paid within a 'short time' after the end of the taxable year in which it was accrued./4/ The regulations under section 404, moreover, allow even longer tax floats if the liability is not precisely determinable:

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Section 404(a)(5) is not intended to cover the case where

an employer on the accrual basis defers payment of compensation

after the year of accrual, as . . . where the liability accrues

in the earlier year but the amount payable cannot be exactly

determined until the later year./5/

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The Committee Reports to the original enactment of the predecessor of section404(a)(5) even said that payee matching 'was not intended to cover the case when an employer on the accrual basis defers payment of compensation after the end of the year accrued merely because of an inability to pay such compensation.'/6/

The outer limits of these exemptions from coverage are vague, but if the effect of these exemptions is to throw the employer back into the common law rules on long term tax floats that it can set up, then tax floats of 10 years,/7/ 11 years,/8/ 13 years,/9/ a working career,/10/ or many years/11/ would be tolerated. 'Mere' contingencies as to the time of payment are said not to defeat deduction of a fixed liability. The Committee Reports to the 1978 Act said that unless payment occurred within a 'reasonable time,' payee matching would apply,/12/ but even seven years has been interpreted as 'reasonable.'/13/

These tax floats are long enough that the employer can make money by incurring liabilities: The tax savings generated by the tax floats is more valuable in time value terms than the compensation itself. When that happens there is no longer any need for the employer to pay tax./14/ Accordingly, the definition of the term 'deferred' has to be tightened up.

The problem would have undoubtedly been fixed in the 1984 legislation had it been apparent on the face of the statutory language or brought to the attention of the Staff. The expansion of section 404(a)(5) in 1984 to 'benefits (other than compensation)' was aimed at the unduly strict judicial construction under prior law of the 'compensation' term in 'deferred compensation' that allowed the tax float abuse./15/ The vagary possible under the term 'deferred' in 'deferred compensation' allows the same mischief.

The best solution is simply to repeal the 'deferred' requirement in section 404(a)(5), just as was done in 1984 for section 267(a)(2). Section 267(a)(2), under prior law, had allowed an accrual deduction on a liability owed to a related party if the liability was paid within 21/2 months after the end of the tax year. The 1984 Act ended the 21/2 month grace period by allowing deductions only when the recipient was paid. Section 404(a)(5) should similarly end even one year tax floats.

Please call on me if I can provide any further aid or information on this issue.

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Sincerely,

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Calvin H. Johnson

Professor of Law

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/1/ Staff Explanation of the Tax Reform Act of 1984 at 542 (explaining section 267(a)(2)).

/2/ Id. at 805.

/3/ See subsection 404(b), 404(a).

/4/ Rev. Rul. 57-88, 1957-1 C.B. 88. See also Kershaw Mfg. Co. v. Commissioner, 313 F.2d 942 (5th Cir. 1963) (payment several months after year end); Avco Mfg. Co. v. Commissioner, 25 T.C. 975, 1001 (1956) vacated on other issues 57-2 USTC Para. 10,021 (2d Cir. 1957) (payment within the following year).

/5/ Treas. Reg. section 1.404(b)-1 (1960).

/6/ Revenue Act of 1942, Sen. Rep. No. 1631, 77th Cong., 2d Sess., 1942-2 C.B. 504, 609, explaining IRC of 1939 section 23(p).

/7/ Oxford Institute, 33 B.T.A. 1136 (1936).

/8/ Denise Coal Co. v. Commissioner, 271 F.2d 930 (3d Cir. 1959).

/9/ Reynolds Metals Co., 68 T.C. 943, 960 (1977).

/10/ Washington Post v. United States, 405 F.2d 1279 (Ct. Cl. 1969) (accrued as employee service performed but paid only after retirement).

/11/ Timken Co. v. United States, 42 AFTR 2d 5740 (Ct. Cl. 1978).

/12/ H. Rep. No. 95-1445, 95th Cong., 2d Sess. 62 (1978); S. Rep. No. 95-1263, 95th Cong., 2d Sess. 74 (1978).

/13/ Cyclops Co. v. United States, 408 F.Supp. 1287, 1299 (D. Pa. 1976) (seven years between accrual and payment).

/14/ IRC section 467(g) added by the Tax Reform Act of 1984 authorizes prospective regulations to impute interest on deferred payments for services, but only for transactions in excess of $250,000. Imputed interest, moreover, will prevent cost-free liabilities only if the imputed rate equals or exceeds d/1-T, where d is the after-tax discount rate and T is the tax rate, and the imputed rates are not high enough to do that. The imputed interest rate works, for instance, only if it is twice the municipal bond rate.

IRC section 461(h) added by the Tax Reform Act of 1984 defers deductions unless services are performed within 81/2 months of the following year, but does not prevent long deferred payments.

/15/ See, e.g., Greensboro Pathology Associates v. United States, 698 F.2d 1196 (Fed. Cir. 1982) (education benefits to kids of employees was exempt from payee matching as not 'deferred compensation').

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