By R. Dan Fesler, Larry Maples, and Bob G. Wood, Jr.
When to Record Income or Deductions
A letter of credit (L/C) is often thought of in the context of purchasing and importing products from a foreign vendor. The tax aspects of L/Cs, however, are another matter.
The first consideration is how the use of an L/C affects the timing of income and deductions. Income timing is affected by the rules on installment sales, whether the L/C is a cash equivalent, and whether it is part of a like-kind exchange. Both cash and accrual basis taxpayers may be affected if a contested liability exists. An L/C secured by taxpayer assets can accelerate a deduction for a contested liability unless tort or workers' compensation liability is involved.
Other uses for an L/C are to stay assessment and collection until a court decision is rendered and to extend the collection period beyond the statute of limitations.
Taxpayers, the IRS, and the courts are increasingly faced with the question of the tax effects of transactions facilitated by letters of credit (L/C). The timing of income and deductions is often at the core of the interpretive difficulties. But the L/C may also impact assessment and collection actions, like-kind exchanges, and other areas (See the Sidebar).
Accrual basis taxpayers cannot defer income with the L/C. Since receipt of a note is taxable in a sale, securing a note with an L/C or a standby L/C (SLC) is incidental from a tax standpoint. Cash basis sellers, however, have argued that an L/C is merely security for a note and, thus, nontaxable until the seller collects either the note or the proceeds from the L/C. On the other hand, the IRS has often taken the position that an L/C is a cash equivalent under IRC section 451. The IRS has an easier time sustaining this position for an L/C that has no marketability restrictions.
Cash Equivalency. Regulations under IRC sections 446 and 451 provide that if an income item is received, it must be included in income in the year of receipt, regardless of its form. Also, property received with a readily realizable market value is included in the computation of a gain or loss under IRC section 1001 and its regulations. Thus, there is authority that income should be recognized in the year of receipt regardless of its character. But, following this principle would mean no difference between the cash and accrual methods in situations involving notes. Therefore, the courts have developed the cash equivalency doctrine to determine whether intangible property such as notes should be recognized upon receipt by cash basis taxpayers.
Cowden [61-1 USTC 9382, 289 F2d 20 (CA-5, 1961), rev'g 20 TCM 1635 (1961)] is the case most cited by cash basis taxpayers wishing to defer income on notes or other instruments. Under the decision, the fact that an item has a fair market value does not necessarily mean it is a cash equivalent. An instrument should be treated as a cash equivalent only if it meets several conditions, including transferability and an existing market where the instrument would not trade at a deep discount.
The Ninth Circuit articulated a different view of cash equivalency in Warren Jones [75-2 USTC 9732, 524 F2d 788 (CA-9, 1975) rev'g 60 TC 663 (1973)]. In that case, a ready market existed for the obligations in question, even though they were being sold for substantial discounts. Following Cowden, the Tax Court had held that the obligation was not a cash equivalent due to the substantial discount. However, the Court of Appeals reversed and held that the fair market value had to be included in the amount realized on the transaction. The court reasoned that the hardship a taxpayer might suffer from this decision is cushioned by the availability of installment reporting.
This may be of little comfort for taxpayers when the IRS treats the security for a note as a payment under the installment rules discussed below. Moreover, the cash basis taxpayer who elects out of the installment method may find she is taxed on the fair market value of the obligations whether or not there is an existing market for such obligations. The Treasury has said, in Regulations section 15A.453-1(d)(2)(i), that it will tax an obligation at value "whether or not such obligation is the equivalent of cash." A taxpayer who elects out of the installment method may find that the Warren Jones precedent recharacterizes income. Receipt of a note on the sale of a capital asset would be reported at its discounted value. Eventual collection of the face amount of the note would result in ordinary income for the excess of the amount collected over the value repored earliered earlier.
In Watson [80-1 USTC 9302 (CA-5, 1980) aff'g 69 TC 544], the Fifth Circuit decided that an L/C received by a seller of cotton was taxable in the year of receipt rather than in the following year, when the L/C was paid. Although the court did not refer to Warren Jones, it appeared to use the same "ready market value" rationale. Could a taxpayer avoid this ready market rationale with an SLC because it is nontransferable? The Tax Court in Griffith [73 TC 933 (1979)] rebuffed a taxpayer who argued that he had expressly made the SLC nontransferable to avoid the ready market problem. The court concluded that even if the letter is nontransferable, the proceeds may be transferred under applicable state law. The Tenth Circuit vigorously disagreed with this reasoning in Sprague [80-2 USTC 9621, 627 F2d 1044 (CA-10, 1980) rev'g DC, 76-2 USTC 9566], arguing that IRS attempts to tax the security underlying a note are efforts to tax cash-basis taxpayers on notes that are merely more collectible
than other notes. Current Statutory and Regulatory Framework. Against this background of judicial conflict over the L/C and escrow accounts, Congress made amendments to IRC section 453 by redefining "payment" in the Installment Sales Revision Act of 1980: "Payment does not include the receipt of evidences of indebtedness of the person acquiring the property" (whether or not payment of such indebtedness is guaranteed by another person).
The plain language indicates that third-party guarantees are not to be treated as payments. The IRC does not define third-party guarantees, but the Treasury, in Temporary Regulations section 15A.453-1(b)(e) narrowly restricts third-party guarantees to SLCs. The justification for this narrow interpretation is that the applicable committee report mentions only SLCs: "The committee believes that a third-party guarantee (including a standby letter of credit) used as security for a deferred payment sale should not be treated as a payment received on an installment obligation."
This statement appears to use "standby letter of credit" not as synonymous with, but as an example of, a third-party guarantee. Nevertheless, it would be prudent to use an SLC rather than an escrow account in structuring an installment sale to clear the IRS definitional hurdle. Examples in the temporary regulations clearly indicate that escrow accounts will not be considered third-party guarantees.
This distinction between an SLC and an escrow account does not necessarily prevail outside the property sales area. The IRS has privately ruled that, under IRC section 83(a), property transferred in connection with services is taxable to the service provider when rights to the property are not subject to a substantial risk of forfeiture. The regulations define property in this context to include secured promises to pay money in the future. Thus, an SLC purchased by an employer to secure its obligation to pay accrued vacation benefits was "property" in this context and taxable to employees when the SLC was obtained. Interestingly, the IRS would not allow a deduction under IRC section 404(a)(5) until the vacation pay was actually paid to the employee. The Tax Court disagreed and allowed such a deduction in Schmidt Baking Co. (107 TC No. 16, 1996). Nevertheless, a provision of the IRS Restructuring and Reform Act of 1998 overrules this Tax Court decision. Thus, a deduction for vacation pay is not available for the current year unless the vacation pay is actually paid to employees within 2.5 months after the end of the year.
On the other hand, an SLC may not result in acceleration of income in a nonemployment context. In PLR 9043014, the IRS said that a deferred jackpot payout on a progressive slot machine was not taxable to the recipient until paid--despite the fact that the casino purchased an SLC per state regulatory commission requirements. The IRS emphasized that the casino did not set aside any funds in an escrow account and, thus, there was no constructive receipt. Apparently, an escrow account would have triggered income in this nonemployment context, but it was not necessary in the employment context above.
Like-Kind Exchange of Real Property. An SLC can play a major role in a deferred exchange by providing security in the event that a transacting party cannot deliver on a contract. To defer income, the taxpayer must not be in actual or constructive receipt of cash (which triggers a taxable gain). Per Regulations section 1.1031(k)-1(g)(2), a taxpayer has no actual or constructive receipt of cash when the obligation of another party to the exchange is secured by an SLC. This safe harbor terminates once the transferor has immediate and unrestricted right to receive money or other considerations under the arrangement.
Illustration. Landlord (L) would like to exchange his apartment complex for a similar complex on the other side of town. However, no one on the other side of town is interested in an exchange. To arrange an exchange, Middleman (M) is hired. L transfers his property to M with the understanding that M will identify and acquire a suitable apartment complex on the other side of town. M does so and transfers it to L. As security, L could require an SLC from M. L would draw upon this letter only if M failed to deliver the replacement property within the statutory time period.
An SLC can provide security protection against failure by another party to comply with the two statutory time periods that apply to all IRC section 1031 exchanges:
1) replacement property must be identified within 45 days of transfer of the relinquished property and
2) replacement property must be delivered by the earlier of 180 days after transfer of the relinquished property or the due date of the return for the year the relinquished property was transferred.
An L/C generally will not change the timing of a deduction for either cash or accrual taxpayers. However, the economic performance standard and the rules on contested liabilities complicate matters somewhat.Issuance of a note by a cash basis taxpayer has long been treated as a mere acknowledgment that the debt will be paid at a later time. Thus, no deduction is allowed even though a note is adequately collateralized [Helvering v. Price 209 US 409 (1940), Eckhert v. Burnet 283 US 140 (1931), and John B. Howard 36 TCM 1140 (1977)]. The fact that a similar note could have been issued to a third party and the funds used to obtain a deduction is irrelevant (Rev. Rul. 76-135, 1976-1 CB 114). Use of an L/C would then appear to have no impact on a deduction for a cash basis taxpayer.
For example, a cash basis individual was not allowed to deduct the cost of feed where he promised to pay the expense and secured the promise with an L/C that was not drawn against. The L/C was considered analogous to a promissory note secured by collateral [H. Chapman 82-1 USTC 9119, 527 F. Supp. 1053 (DC, 1982)]. As discussed below, however, an L/C can apparently trigger a deduction in a contested liability situation.
An L/C would seem superfluous in meeting the all-events test for accrual taxpayers because the fact and amount of a liability would be established by a note, whether undergirded with an L/C or not. However, economic performance has been defined as "payment" with respect to tort claims and liability under workers' compensation. Thus, taxpayers that incur such liabilities must defer deductions until payment is made. Will issuance of an L/C constitute "payment" for this purpose? Regulations section 1.461-4A specifically states that an SLC will not meet the payment criterion. However, if the liability is contested, an L/C may meet the transfer requirement of IRC section 461(f) in some circumstances.
Contested Liabilities. Regulations section 1.461-1(a)(2) allows accrual taxpayers to deduct an expense only when all events have occurred to fix the fact of liability and the amount can be determined with reasonable accuracy. If a liability is contested, the courts have long held that it is not fixed and, thus, not deductible. The Supreme Court in Consolidated Edison [61-1 USTC 9462, 366 US 380 (S. Ct. 1961), aff'g 60-2 USTC 9485 (CA-2, 1960)] even required a taxpayer who had already made payment wait for a deduction until the contest was resolved. Congress added IRC section 461 to give relief to taxpayers who transfer money or other property to satisfy a contested liability. The IRS has construed this transfer requirement narrowly and has had mixed success in the courts.
The purchase of an L/C apparently will not satisfy the transfer requirement unless backed by a pledge of assets. In Williamette Industries Inc. [92 TC 1116 (1989)], a taxpayer funded a $20 million trust with the purchase of an L/C for $85,000. When the L/C was purchased on December 28, 1981, Williamette was contesting an antitrust case that it had lost at the trial and appeal levels. The L/C required the Bank of America to pay the amount of the letter to the trustee on December 31, 1986, if it had not been drawn upon in full prior to that date. There was a loan agreement on the reverse side of the L/C that obligated Williamette to repay the bank within 90 days of withdrawal, with interest at 103% of the prime rate. An accompanying trust agreement obligated the trustee to draw upon the L/C in the event of a final judgment against Williamette. Williamette argued for a deduction in 1981 on the grounds that a transfer took place when the L/C was purchased, but the Tax Court said a transfer only occurs when a loan is made. In this case, a loan would not be triggered until a final judgment was entered.
The taxpayer could have taken a deduction in 1981 if it had borrowed $20 million from the trustee bank and placed the funds in trust. This alternative would overcome the court's complaint that the original transaction did not transfer taxpayer funds but merely shifted the taxpayer's contingent liability to the bank.
But an L/C may produce a deduction if secured by taxpayer assets. In Chem Aero, Inc. [82-2 USTC 9712, 694 F2d 196 (CA-9, 1982)], a sales agent sued the company for unpaid commissions and received a judgment of $54,082. State law required the company to post a bond for one and one-half times the amount of the award in order to appeal. The company posted the required bond and collateralized it by an irrevocable L/C from a bank. The L/C could be applied at any time against a certificate of deposit in the amount of $100,000. The company claimed a deduction the year it collateralized the appeal bond. The Ninth Circuit considered the IRS's contention that the deduction belonged in a later year when the appeals court affirmed the trial court's judgment. However, the court noted that the deduction claimed was less than the collateral. Thus, there was no risk of tax abuse in allowing an earlier deduction.
But the amount of collateral may be irrelevant if the economic performance rules are not met. Since IRC section 461(h) applies the economic performance test to contested liabilities, it is crucial to consider the type of contest involved. Economic performance with respect to tort claims and liability under workers' compensation occurs as payments are made to the claimant according to IRC section 461(h)(2)(C). In Maxus Energy Corporation [94-2 USTC 50, 393, 31 F3rd, 1135 (CA-FC, 1994) (vac'g and rem'g unreported Fed Cl)], the execution of an L/C was not economic performance, because no money or its equivalent was actually paid to anyone in the year the deduction was claimed. Thus, a manufacturer of Agent Orange was not entitled to deduct amounts transferred to a settlement fund until the year payments were actually made. The fact that the company utilized a fully collateralized L/C was immaterial. Interestingly, a deduction probably would have been allowed in this situation under proposed regulations. However, those regulations were withdrawn and the matter of IRC section 461(f) funds reserved for future consideration.
Although the intent of IRC section 461(f) was to alleviate the problems of accrual taxpayers, Regulations section 1.461-2(e) implies that the section also applies to cash method taxpayers. The regulation states that the existence of a contest must be the only factor preventing a deduction for the year of transfer or "for an accrual taxpayer in an earlier year." Thus, taxpayers not on the accrual basis appear to be covered by the rule. If this is correct, a cash basis taxpayer could use a collateralized L/C to obtain a deduction, as in Chem Aero. Does this mean that a cash basis taxpayer who normally could not get a deduction using a collateralized L/C (see Helvering and Chapman) could receive a deduction if the liability were contested? This conclusion runs counter to common sense, yet regulations appear to sanction it.
Assessments, Collections, and Tax Liens
An L/C may be a useful device to stay assessment and collection of Tax Court deficiencies until a subsequent judicial decision. IRC section 7485 requires the taxpayer to file a bond to obtain such stay. According to Black's Law Dictionary, a bond is a "written instrument with sureties, guaranteeing faithful performance of acts or duties contemplated." In Adolph Coors [62 TC 300 (1974)], the bank issuing an L/C was considered adequate surety. Black's defines a "surety" as "one who undertakes to pay money or perform other acts in the event that his principal fails therein."
At trial, both Coors and the IRS agreed that the bank L/C "absolutely" guaranteed and obligated the First National Bank of Denver to pay the IRS should Coors be unsuccessful in its appeal to the Tenth Circuit Court of Appeals. In this case of first impression, the court indicated its reluctance to approve surety where any reasonable doubt of collectibility might exist. Nevertheless, per IRC section 7485 (a)(1), the court had full authority to decide the matter. Focusing on the bank's unconditional promise to pay and sufficient resources, the court held that the bank L/C was adequate surety. Accordingly, the Tax Court's assessment and collection of taxes was stayed until a decision was made by the appeals court.
In Rodrigues (TC memo 1982-324 44 T.C.M. 90), a deficiency had been assessed by the Tax Court, and the taxpayer followed proper procedure (by obtaining an L/C) to stay collection until review by the Ninth Circuit. The Ninth Circuit Court ordered the case back to the Tax Court for a redetermination. Upon review, the Tax Court determined that there should be no deficiency of tax assessed. The taxpayer argued that, under Rule 39 of Federal Rules of Appellate Procedure, a successful appellant is entitled to all costs unless otherwise ordered. But the Tax Court agreed with the IRS that in a case against the government there must be independent authority before awarding such costs to the taxpayer. Thus, Rodrigues was unable to recover the cost of the bank L/C.
Extension of Collection Period
An L/C can extend the collection period past the statute of limitations. In Julicher [95-2, USTC 50, 379 (DC-PA, 1995)], the IRS and the taxpayer agreed that under section 6502(a), the statute of limitations for collection of 1974 employment taxes expired on May 19, 1991. Earlier, on September 13, 1990, Royal Bank had issued an irrevocable L/C for $110,000 in favor of the IRS. Its terms mandated that the $110,000 was to be paid to the IRS if the district director made a statement in writing to Royal Bank that a final judgment had been granted in favor of the IRS, or if the district director presented a written statement stating that the collateral provided by Julicher was insufficient to secure the two Federal tax claims pending against him. The terms of the letter also stated that it was being issued in exchange for a stay of collection of the assessed employment taxes. The L/C was to expire on December 31, 1992.
On December 23, 1992, the district director presented the proper document to Royal Bank and on January 4, 1993, the bank paid the IRS $110,000. Julicher argued that the statute of limitations had run and thus the payment of $110,000 to the IRS was improper. The court rejected this reasoning and pointed out that the sole purpose of the L/C was to stay collection of the employment taxes that had been assessed. In fact, the terms of the L/C expressly stated that it was issued "in exchange for a stay of collection by the IRS." The court ruled that the L/C provided the IRS another means to collect taxes owed because it created a cause of action separate and distinct from the action to collect the outstanding employment taxes.
When Is an L/C Security Interest Superior to a Federal Tax Lien? IRC section 6321 provides the statutory authority for Federal tax liens. In short, this section allows the government to place a lien on "all property and rights to property, whether real or personal," belonging to a delinquent taxpayer. A Federal tax lien applies to any and all property owned and acquired by a delinquent taxpayer during the life of the lien unless the property is exempted by Federal law.
Such an exemption exists for claims associated with an L/C and other types of "obligatory disbursement agreements." Regulations section 301.6323(C)-3 defines an obligatory disbursement agreement simply as an agreement entered into by a person in the course of trade or business to make disbursements where the obligation to pay is beyond the control of the obligor. A Federal tax lien is generally invalid with respect to an L/C security interest when the criteria spelled out in the regulations are met. *
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