Rev. Rul. 68-631

The Internal Revenue Service has been requested to state its position respecting the time for accrual of a deduction for Federal income tax purposes of additional State income taxes asserted against a taxpayer for prior years which have not been paid.

Section 461 of the Internal Revenue Code of 1954 provides, in general, that the amount of any deduction or credit allowed shall be taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income.

The general rule applicable to taxpayers who keep their books and file their returns on the accrual method is that expenses should be accrued and deducted in the year in which the liability therefor is incurred. Section 1.461-1(a)(2) of the Income Tax Regulations. All events must occur to fix a liability of the obligor before an obligation can be recognized by accrual on a taxpayer's books of accounts. United States v. P. Chauncey Anderson et al. , 269 U.S. 422 (1926), T.D. 3839, CB. V-1, 179 (1926).

Thus, an obligation is considered contingent when the existence of any liability at all is uncertain or when its existence depends upon the happening of a future contingent event. When a taxpayer disagrees with the determination of an additional tax liability, he is disputing or contesting the existence of such additional liability. Therefore, until this contingency disappears and the fact of additional liability becomes fixed and certain, there can be no accrual for tax purposes of the additional tax liability.

In G.C.M. 25298, C.B. 1947-2, 39, the term `contest' was held to include a contest lodged with the tax authorities as well as a contest in court. Therefore, unpaid amounts asserted against a taxpayer as additional tax liabilities, which amounts are the subject of a bona fide contest, are not accruable items for Federal income tax purposes.

However, a mere discrepancy between the amount of the tax originally stated to be due by a taxpayer on a tax return and the amount finally determined does not necessarily imply a contest.

In Dravo Corporation v. United States , 348 F.2d 542 (1965) the United States Court of Claims considered the question of what constitutes a contest. In response to the Government's argument that the mere filing of a State tax return acknowledging a liability in a stated amount is a `contest,' since that entails a denial by the taxpayer that it owes an amount of tax greater than that specified on the return, the court replied that, by the same token, the argument could be made that a taxpayer in a self-assessment situation remits what he thinks is the proper amount but acknowledges that a greater amount might be due and levied by the tax authorities. The court concluded that, if the departure from traditional concepts of proper accrual tax accounting is required by the fact of contest, that fact should be evidenced by the taxpayer's objective acts, i.e., lodging a formal protest with the tax authorities or instituting a suit in a court of law. In addition to the Dravo case, the question of what constitutes a contest for accrual purposes was similarly decided in National Forge & Ordance Co. v. United States , 158 F.Supp. 860 (1958).

Revenue Ruling 57-105, C.B. 1957-1, 193, holds that an increase in the amount of State tax accrues and is allowable as a deduction to an accrual basis taxpayer for Federal income tax purposes when the amount is finally determined by litigation, or default, or when the taxpayer finally acknowledges his liability to the State for the amount of such increase. This conclusion was predicated on the position that the mere filing of a State tax return is a denial of any greater amount than the amount stated on the return. Revenue Ruling 59-59, C.B. 1959-1, 97, clarified Revenue Ruling 57-105 as to the effect of this conclusion on returns filed for periods prior to May 1, 1957.

In the light of the Dravo and National Forge decisions the Internal Revenue Service will no longer consider the mere filing of a return as a contest in the absence of some objective act of protest or affirmative evidence of denial of liability by the taxpayer. In the absence of such act or evidence, any additional State taxes subsequently found to be due upon audit will be deemed for Federal income tax purposes to relate back to the year for which the taxes were originally imposed.

Pursuant to the authority provided by section 7805(b) of the Code, taxpayers will not be required to apply the conclusion of this Revenue Ruling with respect to State income tax deductions properly allowable for taxable years beginning before January 1, 1965. However, to the extent that the period of limitation has not expired for such years, claims for credit or refund may be filed on the basis of this Revenue Ruling.

Revenue Ruling 57-105 and Revenue Ruling 59-59 are hereby revoked.