Tax Court Addresses Claim of Offset Against Deferred Payments

Editor: Mary Van Leuven, J.D., LL.M.

In a Tax Court case published on January 28, 2009, Trinity Industries, Inc., 132 T.C. No. 2, the court required the taxpayer to accrue in income, in the year it is earned, the total contract price for the sale of barges—including amounts withheld by customers against deferred payments because of a commercial contract dispute. The taxpayer (Trinity) treated the withheld amounts as nonaccruable. In addition, the Tax Court denied Trinity’s deduction of the withheld amount as a Sec. 461(f) contested liability because Trinity failed to transfer money for the satisfaction of the liability.

Facts

Trinity, an accrual-method taxpayer, entered into a series of contracts with two customers in the late 1990s to provide barges. Trinity generally recognized revenue upon the delivery date of the barges. In 2000, Trinity entered into a second contract with the customers to provide additional barges for a contract price of $1.29 million: $1 million was due upon acceptance of the barge and the remainder was due within 18 months of delivery. Trinity delivered the barges under the second contract in 2001 and 2002.

After execution of the second contract, the customers complained to Trinity that the coatings of the first barges were defective and caused the barges to rust. Trinity denied any liability. Starting in 2002, the customers filed lawsuits, including petitions to exercise their common law right of offset by deducting damages from the first contract barges against deferred amounts owed for the second contract barges. Trinity ultimately entered into settlement agreements with both customers.

For barges delivered in 2001, Trinity recognized as income the full amount of the sales, including the deferred payments. For barges delivered in 2002, Trinity recognized only the amounts received in 2002, excluding the deferred payments against which the two customers asserted rights of offset.

Issue

The primary issue was: Is Trinity, an accrual-method taxpayer, required to accrue in 2002 deferred payments for barges it delivered in 2002 under the second contract and for which the customers claimed rights of offset for damages arising from the barges previously purchased under the first contract? A secondary issue was: Could Trinity deduct in 2002 the payments withheld by the customers as Sec. 461(f) contested liabilities?

Analysis

The IRS contended that Trinity’s delivery of the barges under the second contract unconditionally fixed its right to receive the full contract price and thus satisfied the requirements for recognition of income for accrual-method taxpayers. Under Regs. Sec. 1.451-1(a), an accrual-method taxpayer generally recognizes income in the tax year in which:

• All the events have occurred that fix the right to receive the income; and
• The amount of the income can be determined with reasonable accuracy.

Absent the claim of offset by its customers, the IRS argued that the income would be recognized when the barges were delivered, regardless of receipt of payment.

Trinity cited numerous cases supporting its position that, because of the customer’s assertion of claims of rights to offset deferred payments, the seller defers income as disputed income until the dispute is settled. Essentially, the prior case law it cited stands for the proposition that an amount of income is not fixed if the obligor disputes the validity and/or the amount of the claim. The Tax Court, however, distinguished Trinity’s factual situation from the cases cited because Trinity’s customers did not dispute the fact or the amount of their obligations to Trinity. The court stated:

By contrast, insofar as the record shows, neither [customer] ever disputed the fact or amount of its obligation to Trinity under the second contract. To the contrary, their filings in the commercial litigation expressly acknowledged their obligations to Trinity under the second contract and indicated that they were setting the withheld amounts aside in “escrow” or as “collateral security” to offset whatever damages Trinity might ultimately be determined to owe them with respect to their claims under the first contracts.

The Tax Court indicated its corresponding view that Trinity “effectively received the withheld amounts when, pursuant to the settlement agreement, they were applied in compromise of [the customers’] claims.” The court further commented that the required event causing accrual, i.e., delivery, had occurred and that collectibility was not doubtful by reason of the customers’ financial conditions.

The secondary issue discussed in the case was whether Trinity was entitled to deduct in 2002 the amount it considered transferred to the customers to settle their disputed claims for damages to the barges from the first contract. Sec. 461(f) allows a deduction if:

• The taxpayer contests an asserted liability;
• The taxpayer transfers money or property to satisfy such liability; UÊ The contest exists after the transfer; and
• But for the existence of the contest, a deduction would be allowed.

If the Sec. 461(f) requirements are satisfied, then the transferred amount is deductible in the tax year of the transfer. Trinity contended that the customers’ act of withholding payment as an offset for damages satisfied the Sec. 461(f) transfer requirement. The IRS successfully argued, however, that Sec. 461(f) did not apply to the withheld amounts because the withholding did not represent a transfer of money or property beyond Trinity’s control, inasmuch as Trinity never had possession of the money at issue. Even if it did, the amounts could not have been transferred until the underlying deferred payments became due, i.e., after 2002.

Taxpayer Effect

Deferral of income, including contingent or contested revenue, has been a regular point of contention between taxpayers and the IRS. In certain circumstances, the courts and the IRS have permitted the deferral of such income until the dispute has been resolved, under the rationale that in the instance of a contested claim, income is generally not fixed until the claim is determined or settled (see, e.g., Reading & Bates Corp., 40 Fed. Cl. 737 (1998); Letter Ruling 9434013).

Rev. Rul. 2003-10 provides some insight. The IRS ruled that in some situations, an accrual-method taxpayer does not accrue income in the tax year of sale if it shipped the incorrect goods and the customer disputes its liability to the taxpayer. In contrast, Trinity’s customers did not dispute their liability for the sales price of the second set of barges, but instead claimed a right of offset by deducting damages from the first contract barges against deferred amounts owed for the second contract barges. The installment method under Sec. 453 would have provided some relief had it been applicable, but presumably the barges constituted inventory in Trinity’s hands and thus would have been ineligible for installment sale treatment.

The Tax Court’s secondary holding, that Trinity could not deduct in 2002 the amount withheld by the customers as a Sec. 461(f) contested liability, also appears consistent with prior guidance because there was no actual transfer in 2002, per Regs. Sec. 1.461-2(c)(1). In theory, a deduction could have been available, but Trinity presumably would have needed to affirmatively transfer money or property as required in Regs. Sec. 1.461-2. That is, money may need to have changed hands in both directions.

Conclusion

The Trinity Industries decision illustrates the importance of analyzing the facts in the context of contract disputes, including determining what amount is being disputed, whether a holdback or claim of offset is asserted, and when the dispute arises. It further demonstrates that authorities that on the surface may appear applicable (here, concerning disputed revenue and contested liabilities) may not in fact provide the taxpayer’s desired relief.

EditorNotes

Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

This article represents the views of the author or authors only, and does not necessarily rep-resent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

© 2009 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.

For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or mvanleuven@kpmg.com.