Publication 538 - Accounting Periods And Methods (Page 12 of 18) in pdf

until the following year, the shipping costs are

value of the outstanding stock of the cor-

is settled, you must accrue the liability in the

more properly matched to income in the year of

poration and more than 50% of the capital

year in which the contest is settled.

sale than the year the goods are shipped.

or profits interest in the partnership.

Example. You are a calendar year taxpayer

Expenses such as insurance or rent are gen-

11) A personal service corporation and any

using an accrual method of accounting. You had

erally allocable to a period of time. If you are a

employee-owner, regardless of the amount

a $500 liability asserted against you in 1998 for

calendar year taxpayer and enter into a

of stock owned by the employee-owner.

repair work completed that year. You contested

12-month insurance contract on July 1, of year

the asserted liability and settled in 2000 for the

1, allocate half of your expense to year 1 and

Ownership of stock. To determine whether

full $500. You pay the $500 in January 2001.

half to year 2. Expenses that cannot be practi-

an individual directly or indirectly owns any of

Since you did not make the payment until after

cally associated with income of a particular pe-

the outstanding stock of a corporation, the fol-

the contest was settled, the liability accrues in

riod, such as advertising costs, should be

lowing rules apply.

2000 and you can deduct it only in 2000.

assigned to the period the costs are incurred.

The matching requirement is satisfied if the pe-

1) Stock owned directly or indirectly by or for

Transfer to creditor. You must transfer to

riod to which the expenses are assigned is the

a corporation, partnership, estate, or trust

the creditor or other person enough money or

same for tax and financial reporting purposes.

is treated as being owned proportionately

other property to cover the payment of the as-

by or for its shareholders, partners, or ben-

serted liability. The money or other property

eficiaries.

transferred must be beyond your control. If you

Related Persons

transfer it to an escrow agent, you have met this

2) An individual is treated as owning the

requirement if you give up all authority over the

stock owned directly or indirectly by or for

Business expenses and interest owed to a re-

money or other property. However, buying a

the individual’s family (as defined in item

lated person who uses the cash method of ac-

bond to guarantee payment of the asserted lia-

(1) under Related persons).

counting are not deductible until you make the

bility, making an entry on your books of account,

payment and the corresponding amount is in-

3) Any individual owning (other than by ap-

or transferring funds to an account within your

cludible in the related person’s gross income.

plying rule (2)) any stock in a corporation

control will not meet this requirement.

Determine the relationship, for this rule, as of the

is treated as owning the stock owned di-

end of the tax year for which the expense or

Liability deductible. The liability must have

rectly or indirectly by that individual’s part-

interest would otherwise be deductible. If a de-

been deductible in the year of payment, or in an

ner.

duction is denied, the rule will continue to apply

earlier year when it would have accrued, if there

4) To apply rule (1), (2), or (3), stock con-

even if your relationship with the person ends

had been no contest.

structively owned by a person under rule

before the expense or interest is includible in the

Economic performance rule satisfied.

(1) is treated as actually owned by that

gross income of that person.

You generally cannot deduct contested liabilities

person. But stock constructively owned by

until economic performance occurs. For work-

Related persons. For purposes of this rule,

an individual under rule (2) or (3) is not

ers’ compensation or a tort liability, economic

the following persons are related.

treated as actually owned by the individual

performance occurs as payments are made to

for applying either rule (2) or (3) to make

the person. The payment or transfer of money or

1) Members of a family, including only broth-

another person the constructive owner of

other property into escrow to contest an as-

ers and sisters (either whole or half), hus-

that stock.

serted liability is not a payment to the claimant

band and wife, ancestors, and lineal

that discharges the liability. This payment does

descendants.

Reallocation of income and deductions.

not satisfy the economic performance test, dis-

Where it is necessary to clearly show income or

2) Two corporations that are members of the

cussed earlier.

prevent tax evasion, the IRS can reallocate

same controlled group as defined in sec-

gross income, deductions, credits, or al-

tion 267(f).

Recovered amounts. An adjustment is usu-

lowances between two or more organizations,

ally necessary when you recover any part of a

3) The fiduciaries of two different trusts, and

trades, or businesses owned or controlled di-

contested liability. This occurs when you deduct

the fiduciary and beneficiary of two differ-

rectly or indirectly by the same interests.

the liability in the year of payment and recover

ent trusts, if the same person is the grantor

any part of it in a later tax year when the contest

of both trusts.

is settled. Include in gross income in the year of

Contested Liability

4) A tax-exempt educational or charitable or-

final settlement the part of the recovered amount

ganization and a person (if an individual,

that, when deducted, decreased your tax for any

If you use an accrual method of accounting and

including the members of the individual’s

tax year.

contest an asserted liability, you can deduct the

family) who directly or indirectly controls

liability either in the year you pay it (or transfer

Foreign taxes and taxes of U.S. possessions.

such an organization.

money or other property in satisfaction of it) or in

The rule allowing the deduction of contested

the year you finally settle the contest. However,

5) An individual and a corporation when the

liabilities in the tax year of payment does not

to take the deduction in the year of payment or

individual owns, directly or indirectly, more

apply to the deduction for income, war profits,

transfer, you must meet certain conditions.

than 50% of the value of the outstanding

and excess profits taxes imposed by any foreign

stock of the corporation.

government or U.S. possession. This means

Conditions to be met. You must satisfy each

that an accrual method taxpayer deducts these

6) A fiduciary of a trust and a corporation

of the following conditions to take the deduction

liabilities in the tax year in which the contested

when the trust or the grantor of the trust

in the year of payment or transfer.

foreign tax or U.S. possession tax is finally de-

owns, directly or indirectly, more than 50%

Liability must be contested. You do not

termined.

in value of the outstanding stock of the

have to start a suit in a court of law to contest an

Contested foreign taxes accrued for the for-

corporation.

asserted liability. However, you must deny its

eign tax credit are not covered under this provi-

7) The grantor and fiduciary, and the fiduciary

validity or accuracy by a positive act. A written

sion but relate back to and are credited in the tax

and beneficiary, of any trust.

protest included with payment of an asserted

year in which they would have been accrued had

liability is enough to start a contest. Lodging a

they not been contested.

8) Any two S corporations if the same per-

protest in accordance with local law is also

sons own more than 50% in value of the

enough to contest an asserted liability for taxes.

outstanding stock of each corporation.

You do not have to deny the validity or accuracy

9) An S corporation and a corporation that is

of an asserted liability in writing if you can show

Inventories

not an S corporation if the same persons

by all the facts and circumstances that you have

own more than 50% in value of the out-

asserted and contested the liability.

An inventory is necessary to clearly show in-

standing stock of each corporation.

Contest must exist. The contest for the as-

come when the production, purchase, or sale of

10) A corporation and a partnership if the

serted liability must exist after the time of the

merchandise is an income-producing factor. If

same persons own more than 50% in

transfer. If you make payment after the contest

you must account for an inventory in your busi-

Page 12

Publication 538 - Accounting Periods And Methods Page 12

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