107 T.C. No. 16 UNITED STATES TAX COURT SCHMIDT BAKING COMPANY, INC., Petitioner v .

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 10458-95. Filed November 14, 1996.

P funded its vacation and severance pay obligations to its employees for 1991 by purchasing an irrevocable letter of credit on March 13, 1992. The letter of credit constituted a transfer of an interest in substantially vested property, includable in income of the employees as of that date under sec. 83, I.R.C. P, an accrual basis taxpayer, deducted the amount of the letter of credit on its 1991 return on the basis that it paid the vacation pay within 2-1/2 months of the close of its 1991 taxable year and was therefore entitled to the claimed deduction under sec. 83(h), I.R.C., and sec. 1.83-6(a)(3), Income Tax Regs. R disallowed the deduction on the ground that the letter of credit did not constitute payment to the employees within the 2-1/2 month period with the result that sec. 404(a)(5), I.R.C., and sec. 1.404(b)-1T, Temp. Income Tax Regs., 51 Fed. Reg. 4321 (Feb. 4, 1986), applied and the deduction was not allowable to P for its 1991 taxable year. Held , the letter of credit constituted payment on March 13, 1992, so that sec. 404(a)(5), I.R.C., does not apply, and the deduction for vacation and severance pay is an allowable deduction for P's 1991 taxable year under sec. 83(h), I.R.C., and sec. 1.83-6(a)(3), Income Tax Regs.

Theodore W. Hirsh

, Andrea R. Macintosh , and Frances M.

Angelos

, for petitioners.

Clare J. Brooks

, for respondent.

OPINION

TANNENWALD, Judge

: Respondent determined the following deficiencies in petitioner's Federal income taxes: Taxable Year Ended Deficiency Dec. 26, 1987 $ 6,982.00 Dec. 31, 1988 193,182.00 Dec. 28, 1991 2,873.00 After concessions, the sole issue for decision is whether petitioner may deduct for its 1991 tax year amounts for vacation and severance pay which accrued in that year, were funded within 2-1/2 months of the end of that year, i.e., March 13, 1992, by means of an irrevocable letter of credit, and were includable in the income of the employees as of that date.

The stipulation of facts and supplemental stipulation of facts are incorporated herein by this reference and found accordingly. Petitioner, an accrual basis taxpayer, is a corporation with over 1,300 employees that, at the time of the filing of the petition, had its principal place of business in Baltimore, Maryland. It filed timely Federal income tax returns for the years at issue with the Internal Revenue Service Center, Philadelphia, Pennsylvania.

Petitioner had in place a vacation plan, whereby vacation earned in the first year could only be taken between January 1st and December 31st of the following year. Terminated employees could get cash for their unused vacation pay with proper notice to petitioner. Petitioner also had a plan of severance pay in the event employees were laid off.

On March 13, 1992, petitioner purchased an irrevocable standby letter of credit in the amount of $2,092,421 representing accrued 1991 liabilities of $1,773,183 for vacation pay and $319,238 for severance pay. Petitioner's employees were designated as the beneficiaries with each employee and the amount of the accrued benefit to which he or she was entitled separately On its return, timely filed, for the taxable year ending December 28, 1991, petitioner deducted all liabilities for vacation and severance pay accrued during that year that were listed in the letter of credit, in the amount of $2,092,421. By way of a net operating loss carryback, petitioner also claimed a set forth in a statutory provision dealing with deferred compensation arrangements but is a creature of regulations and recognition in legislative history. See Avon Products, Inc. v. United States , 97 F.3d 1435 (Fed. Cir. 1996); Truck & Equipment Corp. v. Commissioner , 98 T.C. 141, 145-154 (1992). Second, we recognize that it does not necessarily follow that funds have been paid because they have been constructively received for income tax purposes. See Gillis v. Commissioner , 63 T.C. 11, 17 (1974). Third, the decided cases are less than models of clarity in delineating distinctions in meaning among "included", "received", and "paid", a view reflected in the opinion of the Court of Appeals for the Ninth Circuit in Albertson's Inc. v. Commissioner , 42 F.3d 537, 543 (9th Cir. 1994), affg. 95 T.C. 415 (1990). The Ninth Circuit noted that, for nonqualified plans, "the employer is ordinarily allowed no deduction for contribution, payments or benefits until they are taxed to the employee", which it equated with a denial of the "employer's deduction until the deferred amount is included in the employee's income", meaning in its view that "current law * * * defers the * * * deduction "until the year of payment . The court concluded that "an employer cannot take tax deductions for payments to its employees until the DCA participants include those payments in their taxable income--that is, until the employees actually receive the compensation promised to them." Albertson's Inc. v. Commissioner , 42 F.3d at 543 (citations omitted and emphasis added).

Against the foregoing background, we turn to an analysis of whether there was not only includability in income but also payment as of March 13, 1992. If these two elements are found to be present, we think there need be no further consideration of the word "received" in the regulations because the combination of includability and payment must necessarily be equated with "received". To better understand our analysis, we repeat the text of section 404(a)(5):

(5) Other plans.--If the plan is not one included in paragraph (1), (2), or (3), in the taxable year in which an amount attributable to the contribution is includible in the gross income of employees participating in the plan, but, in the case of a plan in which more than one employee participates only if separate accounts are maintained for each employee. For purposes of this section, any vacation pay which is treated as deferred compensation shall be deductible for the taxable year of the employer in which paid to the employee.

Clearly, section 404(a)(5) on its face provides no clear guidance to the question before us, since it speaks (first sentence) in terms of "includable in income" in respect of deferred compensation other than vacation pay and in terms of "paid" in respect of vacation pay (second sentence). Under these circumstances, we find it appropriate, indeed mandated, that we look to the legislative history, particularly since that history articulates the 2-1/2 month rule, which is our main concern. See Hospital Corp. of America v. Commissioner , 107 T.C. 116 (1996), particularly at 129. Furthermore, the use of legislative history in this case is particularly appropriate where neither party questions the validity of the 2-1/2 month rule, but merely its application.

Prior to 1987, section 404(a)(5) contained only the first sentence; the rules governing vacation pay were contained in section 463, which provided for a deduction based on the establishment of a reserve. In 1987, when the Omnibus Budget Reconciliation Act of 1987, Pub. L. 100-203, 101 Stat. 1330, was being considered, both the House and Senate proposed to repeal section 463 and make no change in section 404(a)(5) as it then stood. In so doing, the House Ways and Means Committee and the Senate Finance Committee discussed the proposed action in the following identical language:

7. Reserve for accrued vacation pay (sec. 10121 of the bill and sec. 463 of the Code)

Present Law

Under present law, an accrual-method taxpayer generally is permitted a deduction in the taxable year in which all the events have occurred that determine the fact of a liability and the amount thereof can be determined with reasonable accuracy (the "all-events" test). In determining whether an amount has been incurred with respect to any item during the taxable year, all events that establish liability for such amount are not treated as having occurred any earlier than the time economic performance occurs (sec.

461(h)). With respect to a liability that arises as a result of another person's providing services to the taxpayer (such as the liability to provide vacation pay in exchange for service by an employee), economic performance generally occurs when such other person provides the services.

In order to ensure the proper matching of income and deductions in the case of deferred benefits ( such as vacation pay earned in the current taxable year, but paid in a subsequent year ) for employees, an employer generally is entitled to claim a deduction in the taxable year of the employer in which ends the taxable year of the employee in which the benefit is includible in gross income (sec. 404(b)). This rule applies to deferred benefits without regard to the economic performance rules. Consequently, an employer is entitled to a deduction for vacation pay in the taxable year of the employer in which ends the earlier of the taxable year of the employee for which the vacation pay (1) vests (if the vacation pay plan is funded by the employer), or (2) is paid .

An exception to this rule applies to amounts that are paid within 2-1/2 months after the close of the taxable year of the employer in which the vacation pay is earned. Such amounts are not subject to the deduction timing rules applicable to deferred benefits, but are subject to the general rules under which an employer is entitled to a deduction when performance occurs (i.e., when the services of the employee for which vacation pay is earned are performed). Because amounts paid within 2-1/2 months after the close of the employer's taxable year generally will qualify for the exception to the economic performance requirements, such amounts generally will be deductible for the preceding taxable year (the year in which the vacation pay is earned) even though the employee does not include the benefit in income in the preceding taxable year.

* * * * * * * Reasons for Change The special rules under present law relating to the reserve for accrued vacation pay create a disparity in tax treatment between accrued vacation pay and other deferred benefits. The committee believes that the timing of deductions for vacation pay should not be more favorable than the timing of deductions for other deferred benefits.

Explanation of Provision

The special rule that permits taxpayers a deduction for additions to a reserve for vacation pay would be repealed. Accordingly, under the bill, deductions for vacation pay would be allowed in any taxable year for amounts paid, or funded amounts that exception to the general rule for deferred compensation and deferred benefits pursuant to which an employer is allowed a deduction for the taxable year of the employer in which ends the taxable year of the employee in which the compensation or benefit is includible in gross income . [H. Conf. Rept. 100-495, 920 (1987), 1987-3 C.B. 193, 201; emphasis added.]

Respondent argues that this change, coupled with the absence of any reference to funded and vested amounts, shows that the conference committee (and hence the Congress which enacted the added sentence) intended to exclude such amounts from payment and permit only actual "cash in pocket" to be considered as having been paid. Again, we disagree. A careful reading of the conference committee report shows that the committee was making a change only in the timing of the deduction in respect of vacation pay in contrast to the timing of other deferred compensation payments, and then only in the context of clear recognition that its change applied only to payments after the 2-1/2 month period. Having found our way through the statutory briarpatch of sections 83, 162, and 404 and the regulations thereunder, it is obvious that the disposition of this case turns on a single, straightforward question, namely whether petitioner paid the vacation and severance pay within the 2-1/2 month period. Viewing the totality of the statutory and regulatory provisions and the pertinent legislative history in their entirety, we think that petitioner did so by means of an irrevocable parting of funds, through the creation of the letter of credit, with the separately designated employee-beneficiaries, which was not subject to the claims of petitioner's creditors and which constituted amounts includable in the income of such employeebeneficiaries as of March 13, 1992. As a consequence and in accordance with section 1.404(b)-1T, Temporary Income Tax Regs., neither the vacation nor the severance pay constituted a deferred compensation plan to which section 404(a)(5) applies. This being the case, section 83(h) and section 1.83-6(a)(3), Income Tax Regs., apply, and petitioner is entitled to deduct the amounts in question in accordance with its normal accrual method of accounting, i.e., for its fiscal year ending December 28, 1991.

In order to take into account concessions by petitioner on other issues, Decision will be entered under Rule 155 .