Tax Deduction Depends on Performance

December 31, 2013

The Tax Court has determined that payments to a qualified settlement fund may be deducted by an accrual method S corporation only when economic performance occurs and payments are actually made to the fund.

A qualified settlement fund (QSF) is a fund, account or trust established under governmental order or approval to resolve or satisfy claims resulting from events that gave rise to certain liabilities.

In this case, Vidal Suriel owned all of the shares of an S corporation, Vibo Corp. Vibo sold cigarettes. Although Vibo did not own any cigarette manufacturing or packaging equipment, it contracted production with an unrelated Colombian company.

Vibo used the accrual method of accounting for tax purposes. It claimed deductions for unpaid obligations, both principal and interest, owed to the Tobacco Master Settlement Agreement (TMSA) fund, a QSF. The IRS disallowed the deductions on the basis that economic performance had not occurred until payment was actually made into the TMSA fund.

Vibo argued that its obligation arose from the sale of cigarettes by the Colombian company to Vibo. As such, economic performance occurred as the Colombian company provided cigarettes to Vibo.

In essence, Vibo argued that it was assuming the Colombian company’s TMSA payment obligations as a cost of purchasing cigarettes. Vibo said that it should be allowed to deduct the payment obligations as an ordinary and necessary business expense or cost of goods sold.

The IRS argued that Vibo was required to make the payments to the QSF and that economic performance did not occur until Vibo actually made the payments.

The court agreed with the IRS and held that Vibo was not entitled to deductions for unpaid TMSA obligations because economic performance does not occur until the obligations are actually paid. Under Reg. Section 1.468B-3(c), economic performance occurs with respect to a liability to a qualified settlement fund to the extent the obligor pays into the fund to resolve the liability.

Further, because the special rules governing QSFs do not differentiate between interest and principal, no deduction was allowed for the unpaid interest portion (Suriel v. Commissioner, 141 TC No. 16, Dec. 4, 2013).