Poirier & McLane Corporation v. Commissioner of Internal Revenue

547 F.2d 161, 39 A.F.T.R.2d (RIA) 336, 1976 U.S. App. LEXIS 6104

• Court: Court of Appeals for the Second Circuit
• Decided: November 23, 1976
• Docket: 15, Docket 76-4062
• Status: Published

Opinions

IRVING R. KAUFMAN, Chief Judge:

In 1964, Congress enacted § 461(f) of the Internal Revenue Code to achieve a more equitable and rational matching of liability disbursements and receipts for accrual basis taxpayers. It permitted deduction of a liability, even if contested, provided a transfer was made in that tax year to satisfy the claimed liability. The Internal Revenue Service, to effectuate the statutory intent and avoid potential abuse, promulgated Regulation 1.461-2(c)(l)(ii). It permitted a taxpayer to obtain a deduction by transferring money:

. to an escrowee or trustee pursuant to a written agreement (among the escrowee or trustee, the taxpayer, and the person who is asserting the liability)

We are called upon to decide whether a transfer of funds to a trustee for payment of an asserted liability sometime in the future was deductible under the Regulation, although the claimants were concededly not parties to the agreement. We must also decide whether the requirement of such assent faithfully interprets the intent of the statute. We believe the Regulation plainly requires the person asserting liability to be a party to the trust agreement. Because we are convinced the Regulation contributes to the fairness of the tax structure by limiting § 461(f) to its intended scope, and is designed to forestall potential abuses, we uphold its validity. Accordingly, we reverse the Tax Court’s allowance of a deduction for this payment and remand for a calculation of tax liability.

A concise narration of the facts, which are not disputed, will aid in the consideration of the legal issue. Poirier & McLane Corporation, an accrual basis taxpayer, was a contracting firm specializing in road, bridge and tunnel construction.¹ In January, 1956, the company received a contract from the New York City Transit Authority to reconstruct a subway tunnel and enlarge a subway station in Brooklyn. The Corporation undertook to indemnify the Transit Authority for all claims arising out of the work performed. By the time the project had been completed, several owners and tenants of property in the vicinage of the construction site had filed negligence and trespass suits against the company. The claims aggregated $581,150.

In October 1958, Poirier & McLane secured from New York State a contract to act as general contractor for the construction of a parkway in Yonkers. The agreement contained the familiar indemnification provision. Poirier & McLane engaged a subcontractor, Raymond Concrete Pile Co., to install the road support pilings. It was charged that the subcontractor performed this work improperly, and by driving pilings into an apartment building adjacent to this construction permanently damaged its foundation. In 1960, the building’s owner, Bronxville-Palmer, Ltd., sued Poirier & McLane, Raymond Pile, and the State of New York for negligence and trespass seeking $14,200,000 in damages.

Although Poirier & McLane was insured for aggregate negligence claims up to $500,-000, its policy did not cover liability for trespass. Consequently, the company’s counsel advised that a reserve be set aside to enable Poirier & McLane to pay possible judgments on the uninsured tort claims. Poirier & McLane’s accountant suggested also, that this segregation of funds could be accomplished and an immediate tax deduction taken by placing the money in a trust for the payment of asserted liabilities arising from the Yonkers and Brooklyn construction contracts. Accordingly, Poirier & McLane entered into a trust agreement with Manufacturers Hanover Trust Company. Manufacturers Hanover, as trustee, received $1,100,000 (in a certificate of deposit and Treasury bills), to be held in trust for the sole purpose of paying taxpayer’s obligations on the pending claims and which were allocated in the following manner:

Claim Reserve

The Yonkers Construction $14,200,000 $900,000

The Brooklyn Construction 581,150 200,000

The agreement provided that Manufacturers Hanover would return the balance of the fund after disposition of the claims:

. on the statement of the Settlor that the claims, for the satisfaction of which this transfer has been made, have been determined and disposed of.

In its 1964 tax return, Poirier & McLane, an accrual basis taxpayer, deducted $1,100,-000, on the ground that its transfer of money to the trust constituted payment of a “contested liability”, deductible under 26 U.S.C. § 461(f). On January 20, 1972,² a statutory notice of deficiency was issued to Poirier & McLane, disallowing the deduction and requesting payment of $624,485.37 in additional tax. On April 14,1972, Poirier & McLane filed a petition in the United States Tax Court, challenging the disallowance and denying the existence of a deficiency³ and by a divided court it ruled against the Commissioner.⁴

None of the claimants in any of the pending actions signed this trust agreement, nor were they notified of the existence of the trust. This failure has spawned the legal issue which caused the serious division in the Tax Court.

Judge Featherston, writing for the majority, concluded that Regulation 1.461-2(c)(l)(ii) did not require the persons asserting liability to be parties to the trust agreement. Accordingly, he allowed the deduction of the $1,100,000 placed in trust in 1964. Judge Forrester, in an opinion joined by four other judges, concurred in the result, but added that if the Regulation did contain such a requirement, they would declare that portion of the rule invalid. Judge Hall, in a dissenting opinion joined by three other judges, argued that the claimants assent was required by the Regulation, and that this requirement was a reasonable interpretation of the statutory intent of § 461(f).

I.

An understanding of the Congressional purpose in enacting § 461(f)⁵ is essential before we can determine the appropriate interpretation to be given Regulation 1.461-2(c)(l). The legislative history of § 461(f) plainly reveals that the statute was designed to reestablish and slightly enlarge a narrow exception to the general rules of tax accounting for accrual basis taxpayers, by allowing payments of contested liabilities to be deducted in the year actually paid.

Generally, an accrual basis taxpayer may deduct a liability expense only in “the taxable year in which all events have occurred which determine the fact of the liability and the amount thereof can be determined with reasonable accuracy”.⁶ Where a liability is contingent on the outcome of a contested lawsuit, it is apparent that neither the fact or amount of the expense would be reasonably ascertained, and consequently the expense would not be deductible. Dixie Pine Co. v. Commissioner, 320 U.S. 516, 64 S.Ct. 364, 88 L.Ed. 270 (1943), Lucas v. American Code Co., 280 U.S. 445, 50 S.Ct. 202, 74 L.Ed. 538 (1930).

Until 1960, however, contested tax liabilities actually paid in a given year constituted a narrow exception to this general rule. Chestnut Sec. Co. v. United States, 62 F. Supp. 574, 576, 104 Ct.Cl. 489 (1945), G.C.M. 25298, 1947-2 C.B. 39. The Court of Claims noted “It is hardly conceivable that a liability asserted against [the taxpayer], which he has discharged by payment, has not yet “accrued” within the meaning of the tax laws . . .”

This narrow exception to general accrual rules was eliminated by the Supreme Court in United States v. Consolidated Edison, 366 U.S. 380, 81 S.Ct. 1326, 6 L.Ed.2d 356 (1961). In Consolidated Edison, the company, an accrual basis taxpayer, paid an asserted real estate tax under protest to avoid seizure and sale of its property. Although the corporation continued to challenge a portion of the putative tax bill in court, it deducted the entire deficiency in the year paid. The Supreme Court disallowed the deduction for the contested liability holding that with respect to it, all events determining the fact and amount of the obligation had not yet occurred.

In enacting § 461(f) Congress intended to disapprove this unreasonable application of accrual rules. It allowed payments, by both cash and accrual basis taxpayers, to be deductible in the year of transfer. The statute became applicable to all contested liabilities, not merely tax payments, and was intended to “realistically and practically match receipts and disbursements attributable to specific taxable years.” 1964 U.S. Code Cong, and Adm.News p. 1773. It was Congress’s belief that deduction of the payment in the year “actually made” provided a more realistic reporting of income for tax purposes. In effect, § 461(f) enabled the accrual taxpayer to treat payment of contested liabilities, in appropriate circumstances, as two separate tax events. A deduction was authorized when payment was made, and any subsequent refund was treated as income.

Of course, there is no indication that Congress intended to provide a deduction by simply establishing a contingent liability reserve. Thus, the Senate Supplemental Report⁷ clearly stated that a mere entry on the taxpayer’s books, the purchase of a bond to secure eventual payment of a judgment, or transfer of funds to an account within the taxpayer’s control did not qualify for a deduction. In contrast, the Report indicated that payments to an escrow agent, which placed the assets beyond the control of the taxpayer, were deductible. It is apparent from the legislative history that Congress envisioned the application of § 461(f) to instances resembling that presented in Consolidated Edison, where payment had been “actually made”. By satisfying the asserted claim, the taxpayer fixed the fact and amount of its liability in that taxable year. Thus, accrual of the liability was warranted.⁸

Payments pursuant to an escrow agreement, in most instances, are made after the parties have disposed of many of the contested aspects in the case and only a limited legal issue remains for resolution. Often, such settlements are made after a nisi prius determination of liability and damages, where all that remains open to the losing party is the right to appeal. In such circumstances, we can see little to distinguish a payment to an escrow account from an advance payment of a contested tax liability.

Payments to trusts are not mentioned in the legislative history of § 461(f), for prior to its enactment, there were no tax or any other advantages to be gained by creating a trust to pay contested liabilities. Litigation reserves could be more easily established on the corporation’s books at lesser expense, or by transfer of funds to a specified bank account. The issue in this case, however, is whether Poirier & McLane’s unilateral transfer of assets to a reserve held in trust is the equivalent of payment to an escrow account. In sum, does it constitute a tax event that warrants accrual of the liability and tax deduction in the year of transfer? We believe it does not.

Our dissenting brother, in effect, arrives at the opposite conclusion by announcing that “the important condition precedent” in determining if a payment is deductible under § 461(f) is whether the transfer is made “beyond the taxpayer’s control.” But this overlooks the key consideration that the timing and amount of such transfers may still be entirely within the discretion of the taxpayer, as they were in this case. We do not believe a transfer effectuates the statutory purpose to “realistically match receipts and disbursements for specific taxable years,” merely because the funds are placed beyond the taxpayer’s immediate control. The phrase our brother refers to appears only in the legislative history dealing with escrow accounts which, as we have indicated, closely resemble direct payments. Nor does the dissenting opinion tell us why the unilateral transfer of funds to a trust unknown to the claimants, sufficiently resembles direct payment of the liability or the typical payment of contested funds to an escrow account so that it would deserve deductibility under § 461(f).

II.

The Commissioner closely followed the outlines of the Senate Report in promulgating Reg. 1.461 — 2(c)(1).⁹ The Regulation provided that deductions were only permitted for payments to trusts that resembled the escrow agreement specifically described by Congress. It assimilated the two arrangements, by stating that a taxpayer may provide for satisfaction of a contingent liability by a transfer “to an eserowee or trustee pursuant to a written agreement (among the eserowee or trustee, the taxpayer, and the person who is asserting the liability).”

The language in the Regulation is clear that an essential requirement for deduction is that the claimants must agree to the establishment of the trust. This requisite forms an integral part of the Regulation, and effectuates the intent of § 461(f). And there is a sound reason for this because the agreement of all the parties, in effect, is the equivalent of a direct payment of the asserted claim. It fixes the fact and amount of the liability in a single taxable year, warranting deduction of the payment as a distinct tax event.

The wisdom of this Regulation is manifested by the facts of this case. Poirier & McLane has failed to offer any reason to regard 1964 as the year its liability accrued. The claims against it had been filed more than four years earlier. The only significant event occurring in that year was the Corporation’s unilateral decision to establish a contingency reserve. By transferring funds to a trust, rather than an ordinary bank account, it has asserted that a deductible “payment” was made under § 461(f). Unlike the taxpayer in Consolidated Edison, however, Poirier & McLane was not required to make any payment in 1964. Nor did the exigencies of litigation compel the company to establish the trust. Its decision to do so was totally voluntary, unilateral and principally dictated by tax motives.¹⁰

A statute designed to “realistically match receipts and disbursements” for specific taxable years should not be interpreted to permit a taxpayer to create a deduction in a year of his choosing by the simple expedient of transferring assets to a trust.¹¹ Protests that the Regulation places taxpayers in an “unnatural litigating position” by requiring disclosure of their evaluation of the claim are irrelevant. The statute does not purport to grant a “right” to a deduction. Rather § 461(f) authorizes a departure from the general principle of accrual in very limited circumstances, and taxpayers like Poirier & McLane, whose contested liabilities never became reasonably ascertainable, may not take shelter under its narrow roof.

The requirement that claimants be made parties to the trust agreement is also a useful safeguard against abuses of 26 U.S.C. § 461(f). Unlike direct payments to plaintiffs, transfers to trusts can form great potential for misuse. There is little reason to assume solicitude by the settlor towards the beneficiary of such a trust. There may be a strong temptation for the taxpayer not to relinquish full control, especially when the trustee is a personal friend rather than a disinterested bank.

If the claimants are aware of the trust arrangement, as they are required to be under the Regulation, they can ensure that its assets remain beyond the taxpayer’s control. While it is true that the trustee has an independent duty to safeguard trust property, only the person asserting the liability is likely to be zealous in objecting to a breach of that duty.¹² In a trust such as Poirier & McLane’s, where claimants were never aware of its existence, this important prophylactic measure was lost.

We conclude, therefore, that the assent of the person asserting the liability is required under Reg. 1.461-2(c)(l)(ii). This requirement is an integral means of effectuating the legislative intent of 461(f). Mindful of the strong presumption in favor of the validity of Treasury Regulations, Commissioner v. South Texas Lumber, 333 U.S. 496, 68 S.Ct. 695, 92 L.Ed. 831 (1948), we conclude the Regulation is a reasonable interpretation of the statute.

The trust created by Poirier & McLane concededly did not comply with the requirements of Regulation 1.461-2(c)(l)(ii) as we have interpreted it. Accordingly the Corporation’s payments were not deductible in 1964. The decision of the Tax Court is reversed and remanded with instructions to recompute Poirier & McLane’s tax liability for the years in question, disallowing the deduction of $1,100,000 in 1964.

1 . At the time this case came before the Tax Court, Poirier & McLane, because of business reversals, was in the process of liquidation.

2 . By agreement, issuance of the notice of deficiency was delayed until a final decision was rendered in the Bronxville-Palmer litigation.

3 . In October 1969, Poirier & McLane notified Manufacturers Hanover that all claims enumerated in the trust agreement:

. have been disposed of by final judgment or by compromise and settlement.

On April 15, 1965, a jury found Poirier & McLane not liable for the claims asserted by Bronxville-Palmer. On September 8, 1969, the New York Court of Claims awarded BronxvillePalmer $11,600, plus interest on one of its negligence claims against New York. The record does not reveal the results of the Brooklyn litigation. Subsequent litigation dealt primarily with the appropriate interest to be paid by New York. Bronxville-Palmer v. State of New York, 34 A.D.2d 714, 309 N.Y.S.2d 672, 673 (3d Dept. 1970), rescinded, 36 A.D.2d 10, 318 N.Y. S.2d 57 (3d Dept. 1971), modified 30 N.Y.2d 760, 333 N.Y.S.2d 422, 284 N.E.2d 577 (1972).

4 . 63 T.C. 570 (1975).

5 . 26 U.S.C. § 461(f) states:

(0 Contested liabilities. — If—

(1) the taxpayer contests an asserted liability,

(2) the taxpayer transfers money or other property to provide for the satisfaction of the asserted liability,

(3) the contest with respect to the asserted liability exists after the time of the transfer, and

(4) but for the fact that the asserted liability is contested, a deduction would be allowed for the taxable year of the transfer (or for an earlier taxable year), then the deduction shall be allowed for the taxable year of the transfer. This subsection shall not apply in respect of the deduction for income, war profits, and excess profits taxes imposed by the authority of any foreign country or possession of the United States.

6 . Reg. 1.461-l(a)(2).

7 . 1964 U.S.Code Cong, and Adm.News, p. 1913.

8 . The dissenting opinion does not seem to comprehend our observation that a contested liability is reasonably fixed and ascertainable when actually paid. This does not, of course, mean, nor did we say, the liability is no longer contingent. Con Edison provides the paradigmatic case. The company’s payment of the asserted tax assessment was an event that made the liability sufficiently ascertainable to allow accrual in that year. Nonetheless, the liability remained contested, and thus, contingent.

9 . The Regulation states:

(c) Transfer to provide for the satisfaction of an asserted liability — (1) In general. A taxpayer may provide for the satisfaction of an asserted liability by transferring money or other property beyond his control (i) to the person who is asserting the liability, (ii) to an eserowee or trustee pursuant to a written agreement (among the eserowee or trustee, the taxpayer, and the person who is asserting the liability) that the money or other property be delivered in accordance with the settlement of the contest, or (iii) to an eserowee or trustee pursuant to an order of the United States, any State or political subdivision thereof, or any agency or instrumentality of the foregoing, or a court that the money or other property be delivered in accordance with the settlement of the contest. A taxpayer may also provide for the satisfaction of an asserted liability by transferring money or other property beyond his control to a court with jurisdiction over the contest. Purchasing a bond to guarantee payment of the asserted liability, an entry on the taxpayer’s books of account, and a transfer to an account which is within the control of the taxpayer are not transfers to provide for the satisfaction of an asserted liability. In order for money or other property to be beyond the control of a taxpayer, the taxpayer must relinquish all authority over such money or other property.

10 . We do not comprehend our brother’s continued emphasis on the fact that Poirier & McLane transferred these funds beyond its control, about which there is no issue. Poirier & McLane, however, had absolute discretion over the timing and the relatively arbitrary amount it alone decided to transfer in trust. We do not believe Congress ever intended § 461(f) to permit taxpayers to unilaterally decide when and in what amount to “manufacture” tax deductions.

The dissenting opinion misreads the statute’s requirement that absent a contest, the liability must be deductible in “the taxable year of the transfer (or for an earlier taxable year)”. This does not, as the dissenting opinion suggests, controvert our conclusion. Rather, we believe the statute merely reaffirms that general principles of accrual accounting are applicable; since, if not contested, many of the liabilities covered by § 461(f) would be accrued when they became due, rather than when paid. This certainly does not indicate any Congressional intention to give taxpayers the sole choice of years and amount in which to take the deduction.

11 . Such a deduction resembles the “anticipatory accrual” disapproved by the Tax Court in Overlakes Corp. v. CIR, 41 T.C. 503 (1964), aff'd, 348 F.2d 462 (2d Cir. 1965), cert. denied, 382 U.S. 988, 86 S.Ct. 547, 15 L.Ed.2d 475 (1966).

12 . We believe that the source of this Regulation lies in the legislative history of § 461(f) rather than the intricacies of trust law. We would note, however, that whether the settlor or creditors are beneficiaries of a trust established for the payment of creditors is a question of intent. 2 Restatement of Trusts 2d § 330h, see also Ehag Eisen. Holding AG v. Banca Nat. a Romaniel, 306 N.Y. 242, 251-252, 117 N.E,2d 346 (1954). But if the transfer is pursuant to an agreement with the creditor, the terms of the agreement are controlling on this question. It would not be unreasonable for the Commissioner to allow a deduction under § 461(f) only for trusts that meet this objective standard.