Rev. Rul. 81-93

1981-1 C.B. 322, 1981-12 I.R.B. 13.

                       Internal Revenue Service
                                 Revenue Ruling

          ACCOUNTING METHOD;  CHANGE;  AUDIT ADJUSTMENT;  SELF-INSURER

                           Published: March 23, 1981

SECTION 481.--ADJUSTMENTS REQUIRED BY CHANGES IN METHOD OF ACCOUNTING, 26 CFR 1.48-1: Adjustments in general

(Also Sections 446, 461; 1.446-1, 1.461-1.)

  Accounting method; change; audit adjustment; self-insurer.  Estimated insurance expenses are not deductible.  The change from the use of estimates to the use of actual losses is a change in accounting method, and the balance in the reserve account at the beginning of the year of change must be included in gross income for that year.

ISSUES

  1. May a taxpayer who uses the accrual method of accounting deduct estimated insurance expenses and uninsured losses under section 1.461-2(a)(2) of the Income Tax Regulations?

  2. Is the taxpayer's change from the use of estimates to the use of actual expenditures in accounting for insurance and uninsured loss expenses as required by the Commission of Internal Revenue a change in method of accounting within the meaning of sections 446(e) and 481 of the Internal Revenue Code and, if so, should the balance in the taxpayer's reserve for insurance expense at the beginning of the year of change by included in gross income for that year as an adjustment under section 481 of the Code?

  3. Will the Service withdraw its nonacquiescence and follow the decision of the United States Tax Court in Schuster's Express, Inc. v. Commissioner, 66 T.C. 588 (1976), nonacq., 1978-2 C.B. 4, aff'd per curiam, 512 F.2d 39 (2d Cir. 1977)?

FACTS

  The taxpayer, who transports freight by motor vehicle, is a self-insurer for cargo losses and for the deductible portion of its insured collision coverage. The taxpayer uses the accrual method of accounting.

  For its calendar years 1975 through 1979, the taxpayer used an accounting method under which its estimated its insurance expenses and uninsured losses and maintained a reserve for such items.  Each year, a current deduction based upon a predetermined percentage of gross receipts was claimed as an addition to the reserve account.  The taxpayer charged actual claims against the reserve account.  After examining the taxpayer's federal income tax returns for 1977, 1978, and 1979, the Commissioner of Internal Revenue required the taxpayer to terminate this method of accounting for federal income tax purposes and to use only actual expenditures as the basis for deductions for 1977, the year of change, and subsequent years.  The taxpayer acceded to this change.  Although a balance remained in the reserve account at the close of 1976, the statute of limitations barred the assessment of any federal income tax for that period. This balance represented the prior deductions in excess of actual expenditures.  The Service required the balance of the reserve account to be included in gross income in 1977.

LAW AND ANALYSIS

  Section 461 of the Code states that the amount of any deduction shall be taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income.

  Section 1.461.1(a)(2) of the regulations provides that, under an accrual method of accounting, an expense is deductible for the taxable year in which all events have occurred that determine the fact of the liability and the amount thereof can be determined with reasonable accuracy.

  The "all events" test under section 1.461-1(a)(2) of the regulations is a  "two-prong" test.  First, all events must occur that determine the fact of the liability.  Second, the amount of the liability must be determinable with reasonable accuracy.  See United States v. Anderson, 269 U.S. 422 (1926), V-1 C.B. 179 (1926).  If there is any doubt that the liability will arise, it may

not be deducted until the liability becomes certain.  Brown v. Helvering, 291 U.S. 193, 201 (1934), Ct. D 786, XIII-1 C.B. 223l (1934).

  Section 1.446-1(e)(2)(ii)(a) of the regulations provides that a change of accounting method includes a change in the overall plan of accounting for gross income or deductions, as well as a change in the treatment of any material item within the plan.  Furthermore, a method of accounting is not established for an item unless there is a pattern of consistent treatment.  A material item is defined as any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.

  Section 1.446-1(e)(2)(ii)(b) of the regulations provides that a change in method of accounting does not include correction of mathematical error or the adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item in income or the taking of a deduction, such as the deduction of personal expenses.

  Section 481(a) of the Code provides that in computing a taxpayer's taxable income for any taxable year, if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding taxable year was computed, then there shall be taken into account those adjustments that are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted.

  In the present situation, the taxpayer estimated its insurance expenses and uninsured losses and maintained a reserve for such items.  The use of estimated expenses and losses involves no more than an assumption, based on prior experience, that certain events, probably will occur.  The "all events" test can be met only when the fact of the liability has been clearly established and the amount of the liability can be determined with reasonable accuracy.  When the taxpayer's liability under a method of accounting  is not fixed and certain, the "all events" test is not satisfied.  Because the use of estimated expenses and losses in this situation did not establish the fact of liabilities that were fixed or certain, the "all events" test was not satisfied; therefore, such estimated expenses were deducted improperly.

  The taxpayer's use of a reserve for estimated insurance expenses and uninsured losses involved the proper timing of the deduction of a material item and, thus, constituted a method of accounting.  Under the new method imposed by the Commissioner, the taxpayer must now deduct insurance expenses and losses on the basis of actual expenditures and not on the basis of additions to a reserve.  This is a change in method of accounting to which the provisions of section 446 and 481 of the Code and the regulations thereunder apply.

  Because use of the reserve was discontinued after 1976 without the overestimates being restored to income, and because subsequent expenses would be deducted from income when incurred, there necessarily was a duplication of deductions which section 481 of the Code was intended to prevent.  Therefore, the beginning reserve balance for the year of change must be included in gross income as an adjustment under section 481 of the Code.

  The Court of Appeals in Schuster's Express, Inc. affirmed the decision of the United States Tax Court, which held that the taxpayer's change an accounting for its insurance and uninsured loss expenses did not constitute a change in method of accounting for purposes of section 481 because its prior method was simply wrong and resulted in excessive deductions.  The Tax Court further held that even if the change in question was a change in method of accounting, the balance remaining in the reserve account at the close of 1976 was not subject to section 481 adjustment because any potential duplication of deductions did not arise solely as a result of the change.

  The Tax Court's holding apparently is based on the assumption that had the taxpayer's expenditures exceeded its estimates in future years the taxpayer would have deducted the actual expenditures under its "reserve method." Therefore, the taxpayer had always been on the actual expenditures method but had previously taken a greater deduction than that to which it was entitled. As a result, the Tax Court held that no change in method of accounting had occurred, and that any duplication resulted from erroneous deductions rather than a change in method.

HOLDINGS

  1. The taxpayer may not deduct estimated insurance expenses and uninsured losses under section 1.461-1(a)(2) of the regulations.

  2. The taxpayer's change from the use of estimates to the use of actual expenditures in accounting for insurance and uninsured loss expenses, as required by the Commissioner, is a change in method of accounting within the meaning of section 446(e) and 481 of the Code, and the balance in the taxpayer's reserve at the beginning of 1977, the year of change, must be included in gross income for that year as an adjustment under section 481 of the Code.

  3. The Service will not withdraw its nonacquiescence and will not follow the decision of the Court of Appeals in Schuster's Express, Inc.

Rev. Rul. 81-93, 1981-1 C.B. 322, 1981-12 I.R.B. 13.