Tobacco Retailer Could Not Deduct Settlement Fund Obligation Until Actually Paid (Suriel, TC)

An S corporation wholly owned by the individual taxpayer was not entitled to a deduction for an unpaid settlement obligation because economic performance did not occur until payment was actually made. The S corporation entered into the Tobacco Master Settlement Agreement (MSA), a qualified settlement fund (QSF) under Code Sec. 468B . Although the S corporation did not actually manufacture cigarettes, it was the exclusive importer and distributor in the U.S. of cigarettes made by a South American company. Pursuant to an amendment to the MSA, the S corporation was considered a tobacco product manufacturer (TPM) and, as a signatory to the MSA, a participating manufacturer. The Tax Court rejected its argument that it was not a TPM because it did not manufacture cigarettes.

The S corporation’s liability arose when it signed the MSA, and it did not assume liability from the cigarette manufacturer, which had no liability under the MSA. This was not changed because of a requirement in the S corporation’s agreement with the manufacturer that the S corporation provide reports to the manufacturer regarding its payment of current MSA obligations and its ability to make future payments. Also rejected was the argument that the S corporation entered into the MSA on behalf of the manufacturer at its request, since the court concluded that financial considerations led the S corporation to enter into the MSA voluntarily.

As an accrual taxpayer, the S corporation was entitled to deduct payment obligations as they were incurred, which under Code Sec. 461 meant the year in which all events had occurred that established the fact of the liability, the year the amount of liability could be determined with reasonable accuracy, and economic performance had occurred with respect to the liability. The S corporation’s liability did not arise from services or property provided to the taxpayer (that is, from cigarettes sold to the S corporation by the manufacturer), since the MSA obligation was determined by the S corporation’s share of the cigarette market, not by how many cigarettes it received.

Under Code Sec. 468B(a) and Reg. §1.468B-3(c), economic performance occurs with respect to a liability to a QSF to the extent the obligor pays into the QSF to resolve the liability. The S corporation was not entitled to deduct a large part of its MSA obligation as cost of goods sold in the year at issue because that amount was not actually paid into the QSF and so economic performance did not occur that year.

Finally, the S corporation was not entitled to deduct interest on its MSA obligation that had accrued but had not been paid. It argued that economic performance with regard to interest occurred, under Reg. §1.461-4(e), when the interest cost economically accrued. However, that general provision was overridden by the more specific provisions of Code Sec. 468B(a), which requires payment for economic performance and does not distinguish between interest and principal in the context of a QSF.

V. Suriel, 141 TC —, No. 16, Dec. 59,710

Other References:

Code Sec. 461

CCH Reference – 2013FED ¶21,817.235

Code Sec. 468B

CCH Reference – 2013FED ¶21,951.88

Tax Research Consultant

CCH Reference – TRC ACCTNG: 12,102.20



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