T.C. Memo. 2020-142



                      UNITED STATES TAX COURT



 THE MORNING STAR PACKING COMPANY, L.P., THE MORNING STAR
     COMPANY, TAX MATTERS PARTNER, ET AL.,1 Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 5013-15, 5015-15,              Filed October 14, 2020.
               16684-16, 16842-16.



     Robert R. Rubin, Brian P. Bowen, and Matthew D. Carlson, for petitioners.

     Annie Lee and Julie Ann Fields, for respondent.




     1
       Cases of the following petitioners are consolidated herewith: Liberty
Packing Company, LLC, The Morning Star Company, Tax Matters Partner, docket
Nos. 5015-15 and 16842-16; and The Morning Star Packing Company, L.P., The
Morning Star Company, Tax Matters Partner, docket No. 16684-16.
                                        -2-

[*2]                       MEMORANDUM OPINION


       COHEN, Judge: In notices of final partnership administrative adjustment

(FPAA) for years 2008, 2009, 2010 and 2011 (years in issue), respondent

determined that The Morning Star Packing Co., L.P. (TMSPC), and Liberty

Packing Co., LLC (LPC) (collectively, partnerships), were not entitled to increase

their costs of goods sold (COGS) for the costs to restore, rebuild, recondition, and

retest their manufacturing facilities. These cases were fully stipulated and

submitted to the Court under Rule 122. The stipulations and the simultaneous

briefs of the parties were well crafted, and the uncontested findings are sufficient

to reach our conclusions. There is no issue as to burden of proof. As a result, our

legal analysis set forth in the discussion portion below is concise. Unless

otherwise indicated, all section references are to the Internal Revenue Code in

effect at all relevant times, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

       After concessions, the issues for decision are whether the 2008-11 accrued

production costs were: (1) fixed and binding where economic performance did not

occur until the year following the tax year claimed for and (2) whether the

partnerships’ inclusion of such production costs in COGS for the years in issue
                                         -3-

[*3] resulted in a more proper match against income than inclusion in the taxable

year in which economic performance occurred under the section 461(h)(3)

recurring items exception to the all events test.

                                     Background

      All of the facts have been stipulated, and the stipulated facts are

incorporated as our findings by this reference. Respondent objected to paragraphs

and exhibits relating to prior audits of TMSPC and a related entity that resulted in

no adjustments. There are no penalty issues relating to the disputed adjustments.

Respondent’s relevancy objections are sustained, and those paragraphs and

exhibits are not considered in our opinion. See generally Auto. Club of Mich. v.

Commissioner, 

(1957).

      At the time the petitions were filed the principal place of business of both

partnerships was in Woodland, California. TMSPC is a limited partnership and

LPC is a limited liability company. Both are taxed as partnerships. Both used the

accrual method of accounting, and their financial accounting fiscal years end on

June 30. Each has a calendar yearend for tax purposes because it is required to

have the same yearend as its majority interest partner.
                                        -4-

[*4] The partnerships provide bulk-packaged tomato products to food processors

and customer-branded finished products to the food service and retail trades. They

account for about 25% of the California processing tomato production, supplying

40% of the United States ingredient tomato paste and diced tomato markets.

Production Process

      The annual growing cycle for tomato farmers begins approximately in

October when fields are prepared. Generally farmers purchase tomato seeds in

December. It is common for the partnerships and farmers to have oral agreements

for the purchase of fresh tomatoes by December, with written agreements to

follow. Oral agreements between farmers and processors, such as the

partnerships, are customary in California. About 85% of tomato plants are planted

in hot houses and then transplanted to the fields. In or around June and July

farmers harvest the tomatoes from the fields and deliver them to the partnerships.

Freshly harvested tomatoes have a shelf life measured in days and need to be

processed quickly. The partnerships’ three manufacturing facilities operate 24

hours per day from approximately July to October, about 100 days per year, during

the tomato harvest period.

      When the fresh tomatoes arrive at a facility, they move from a truck into the

facility through a tomato flume to sorting tables, choppers, and hot break tanks.
                                          -5-

[*5] At this point the product is in an airtight, closed, sterile environment. If there

are any air leaks, dirt is sucked into the environment, which reactivates the germs

and bacteria in the product, resulting in a loss of sterility that necessitates shutting

down the production line. The product is propelled by a series of powerful pumps

through holding tanks, finishers, multistage evaporators, and a FranRica flash

cooler to FranRica fillers that package the product in sterile 300-gallon boxes and

55-gallon-drum containers for shipment.

      Heat is a very important element in the evaporation process. The heat is

provided by large natural gas boilers that produce high-pressure steam. The

boilers are subject to stringent emission rules and regulations.

      Food processing facilities that are operated year round are typically

multiline facilities with built-in redundancies. If any one part of a processing line

fails, the entire processing line must cease operation because of a loss of sterility.

In facilities that operate year round the other processing lines are able to

compensate. The partnerships’ facilities are single-line plants with no redundancy.

If any one part of the processing line fails, the entire facility ceases production. If

a facility is not operable for more than a few hours during a season and the fresh

tomatoes cannot be processed because of spoilage, the partnerships are obligated

to pay the farmers the contract price for the tomatoes. The partnerships would also
                                          -6-

[*6] be liable for damages to its customers for failure to provide the promised

tomato paste. For some customers the amount of damages could be very large

because the customer might have to wait until the next growing season for tomato

paste. The resulting payments for the farmer’s and customer’s damages could be

catastrophic for the partnerships.

      The partnerships generally have two types of customers: (1) bill and hold

customers, which account for approximately 30% of sales, and (2) regular

customers, which account for approximately 70% of sales. Bill and hold

customers have contracts pursuant to which each pays an estimated cost before

production for a stated amount of product. Upon completion of production of the

product, title is transferred to the customer; the product is stored at the

partnerships’ sites and shipped at the request of the customer, generally between

August and July of the following year. (For example, tomato paste produced

during 2008 is generally delivered between August 2008 and July 2009.) The

partnerships typically enter into multiyear production agreements with bill and

hold customers. Regular customers may order product at any time. Once such an

order is placed, title to the product is transferred to the customer, removing it from

inventory, and shipped. Generally, inventory is totally depleted by July of the year
                                          -7-

[*7] following production. (For example, tomato paste produced in 2008 is

generally sold by July 2009.)

      The partnerships’ customers generally require that the tomato products

produced meet certain quality and sanitary specifications. Many of the

partnerships’ customers require independent testing to assure sterility and quality.

Because the partnerships contract to supply tomato paste to the U.S. Department

of Agriculture (USDA), their facilities must pass USDA inspections for safety,

sterility, and quality. The U.S. Food and Drug Administration and the State of

California Department of Public Health also inspect the facilities.

Credit Agreements

      During the years in issue the partnerships entered into several credit

agreements with Wells Fargo Bank, U.S. Bank, and Cooperatieve Centrale

Raiffeisen-Boerenleenbank B.A. “Rabobank International” (lenders). On

May 21, 2007, the partnerships executed a third amended and restated credit

agreement (third credit agreement) with the lenders. Under the terms of this

agreement, the lenders agreed to provide credit facilities including revolving

loans, letters of credit, and swing line loans (credit facilities) to the partnerships

for the partnerships’ general business purposes and working capital. The lenders
                                       -8-

[*8] made funds available to the partnerships by the May 31, 2007, closing date,

and the agreement had a maturity date of June 30, 2009.

      The third credit agreement included the following provisions:

      ARTICLE V.         COVENANTS.

            SECTION 5.01. Affirmative Covenants. Until the
      termination of this Agreement and the satisfaction in full by the
      Borrowers of the Obligations, each Borrower will comply, and will
      cause compliance by its respective Subsidiaries, with the following
      affirmative covenants, unless the Required Lenders shall otherwise
      consent in writing:

      *          *           *          *           *           *             *

             (d) Existence, Compliance. Each Borrower and its respective
      Subsidiaries shall (i) maintain all material licenses, Permits,
      governmental approvals, rights, privileges and franchises reasonably
      necessary for the conduct of its business, (ii) conduct its business in
      an orderly and regular manner, and (iii) comply with the provisions of
      all documents pursuant to which such Borrower is organized and/or
      which govern such Borrower's continued existence and with all
      Governmental Rules. [Emphasis added.]

             (e) General Business Operations. Each Borrower and its
      respective Subsidiaries shall (i) preserve and maintain its business
      existence and all of its rights, privileges and franchises reasonably
      necessary to the conduct of its business, (ii) conduct its business
      activities in compliance with all laws and material contractual
      obligations applicable to such Person, and (iii) keep all property
      useful and necessary in its business in good working order and
      condition, ordinary wear and tear excepted, except, in each case,
      where any failure is not reasonably likely to have a Material Adverse
      Effect. * * * [Emphasis added.]
                                      -9-

[*9] *          *           *          *           *            *           *

     ARTICLE VI. DEFAULT.

           SECTION 6.01. Events Of Default. The occurrence or
     existence of any one or more of the following shall constitute an
     “Event of Default” hereunder:

     *          *           *          *           *            *           *

            (d) Other Defaults. Either Borrower defaults in the
     performance of or compliance with any obligation, agreement or other
     provision contained herein (other than those referred to in subsections
     (a), (b) or (c) above), and, such default shall continue for a period of
     twenty (20) days following written notice to Borrowing Agent on
     behalf of such Borrower of such default[.]

     *          *           *          *           *            *           *

            SECTION 6.02. Remedies. At any time after the occurrence
     and during the continuance of any Event of Default (other than an
     Event of Default referred to in Section 6.01(g) or 6.01(h)), Agent
     may, with the consent of the Required Lenders, or shall, upon
     instructions from the Required Lenders, by written notice to
     Borrowing Agent on behalf of each Borrower, (a) terminate the
     Commitments and the obligations of the Lenders to make Loans or
     issue Letters of Credit, (b) declare all outstanding Obligations
     payable by the Borrowers to be immediately due and payable without
     presentment, demand, protest or any other notice of any kind, all of
     which are hereby expressly waived, anything contained herein or in
     the Notes to the contrary notwithstanding, and/or (c) direct each
     Borrower which has one or more Letters of Credit issued for its
     account outstanding to deliver funds to Agent in an amount equal to
     the aggregate stated amount of all outstanding Letters of Credit issued
     for the account of such Borrower. * * * In addition to the foregoing
     remedies, upon the occurrence or existence of any Event of Default,
     Agent may exercise any other right, power or remedy available to it
                                        - 10 -

[*10] under any of the Credit Documents or otherwise by law, either by suit
      in equity or by action at law, or both. [Emphasis added.]

      On August 28, 2008, the partnerships executed a fourth amended and

restated credit agreement (fourth credit agreement) with the lenders. The fourth

credit agreement extended the credit facilities available to the partnerships through

June 30, 2010, and included identical text regarding covenants, default, and

remedies. The partnerships entered into several subsequent agreements with the

lenders that adopted the terms of the fourth credit agreement and further extended

the credit facilities available to them through June 1, 2011. The amount of credit

available to the partnerships during the years in issue pursuant to these collective

credit agreements ranged between $260 million and $90 million.

Production Accrual Liabilities

      The costs in issue are costs to restore, rebuild, and retest the manufacturing

facilities for use during the next production cycle. The accrued production costs

include amounts to be paid for goods and services. The partnerships maintain

reserves that they refer to as “production accrual” (production accrual reserve

accounts). These reserves are used to account for future costs associated with

restoring, rebuilding, and retesting the manufacturing facilities for use during the

next production cycle. The production accrual reserve accounts for both TMSPC
                                         - 11 -

[*11] and LPC included: amounts for production labor, boiler fuel, electricity,

waste disposal, chemicals and lubrication, production supplies, repairs and

maintenance, lease, production wages, and administration wages.

      The accrued production costs were recurring, and the partnerships

determined the amounts to be set aside in the reserves to cover these costs with

reasonable accuracy. The partnerships issue payroll checks every other Thursday

for work performed for the two-week period ending the Saturday before payday.

Thus, payroll was paid between 5 and 19 days after the services were performed.

The partnerships generally paid accounts payable 30 days after the goods and

services were provided. For many reasons, including the sterility of the facilities

when they are in operation, it is most efficient to delay some of the restoring,

rebuilding, and retesting work until closer to the beginning of the next production

cycle. Except for a de minimis amount of goods and services provided and paid

for by December 31, the goods and services are not provided or paid for until the

next year. Hence, economic performance of the production accrual liabilities does

not occur until the next taxable year.

Partnerships’ Accounting and Tax Reporting for 2008 Through 2011

      The partnerships have consistently used the full absorption method of

inventory accounting for all taxable years since each was founded. Accordingly
                                       - 12 -

[*12] the partnerships included as an addition to COGS the portion of the total

accrued production costs equal to the percentage of the year’s production which

had been sold and recognized as income as of December 31. They apportioned the

accrued production costs not included in COGS into ending inventory. They

recognized income for inventory sold to both their bill and hold customers and

regular customers when the partnerships transferred title for the products to each

customer. The partnerships capitalized and depreciated all the costs to put each

processing plant into operation. The partnerships included the accrued production

costs in their audited financial statements for fiscal years ended June 30, 2008-12.

These audited financial statements complied with generally accepted accounting

principles (GAAP).

      Both partnerships filed Forms 1065, U.S. Return of Partnership Income, in

April for each year in issue. They reported the accrued production costs on their

Forms 1065 for each year in issue.

Respondent’s Determinations

      In two FPAAs for years 2008 and 2009 and years 2010 and 2011 for each

partnership, the Internal Revenue Service (IRS) determined that neither was

entitled to increase its COGS for the amount of accrued production costs because:

(1) the partnership had not shown that all events had occurred to establish the fact
                                        - 13 -

[*13] of the liabilities and (2) economic performance had not occurred with

respect to the liabilities to qualify for accrual for the years claimed. The IRS

concluded that if the partnerships’ financial accounting years ended on December

31 instead of June 30, their December 31 yearend financial statements would not

comply with GAAP because the accrued production costs were included in COGS.

The FPAAs showed the following adjustments:

                                    Adjustment      Adjustment
                        Year        for TMSPC        for LPC

                        2008        $4,650,061       $4,060,538
                        2009             16,444      (1,997,954)
                        2010            (97,479)        176,943
                        2011          (591,255)         759,590

In respondent’s opening brief, modifications to the original adjustments were

conceded.

                                     Discussion

      Respondent contends that the accrued production costs that the partnerships

included in COGS for the years in issue were: (1) not fixed and binding until the

following tax year when the partnerships began economic performance and

(2) more properly matched against income for the taxable year in which economic
                                         - 14 -

[*14] performance occurred under the section 461(h)(3) recurring items exception

to the all events test. The partnerships disagree.

All Events Test

      Section 461(a) provides that a deduction must be taken for the proper

taxable year under the taxpayer’s method of accounting. Generally, an accrual

method taxpayer may deduct expenses for the years in which the taxpayer incurred

the expenses, regardless of the actual payment dates. Sec. 461(h)(4); Caltex Oil

Venture v. Commissioner, 

, 23 (2012); sec. 1.461-1(a)(2), Income Tax

Regs. The all events test governs whether a business expense has been incurred to

permit its accrual for tax purposes. See Challenge Publ’ns, Inc. v. Commissioner,

T.C. Memo. 1986-36, 

, at *22, aff’d, 

(9th Cir. 1988). Liability is incurred under the all events test if three factors

are met: (1) all of the events that establish the fact of the liability must have

occurred, (2) the amount must be able to be determined with reasonable accuracy,

and (3) economic performance must have occurred. Sec. 461(h)(4); sec.

1.461-1(a)(2), Income Tax Regs.; sec. 1.461-4, Income Tax Regs. (explaining

economic performance).
                                        - 15 -

[*15] The term “liability” refers to “any item allowable as a deduction, cost, or

expense for Federal income tax purposes.” Sec. 1.446-1(c)(1)(ii)(B), Income Tax

Regs. Thus the production costs reflected in the partnerships’ COGS come within

this definition. To be deductible, a liability must be fixed, absolute, see Brown v.

Helvering, 

, 201 (1934), and unconditional, see Lucas v. N. Tex.

Lumber Co., 

, 13 (1930). A liability may not be deducted if it is

contingent upon the occurrence of a future event. See Lucas v. Am. Code Co.,

, 452 (1930). “Generally, the fact of a liability is established on the

earlier of: (1) the event fixing the liability, such as the required performance or

(2) the date the payment is unconditionally due.” VECO Corp. & Subs. v.

Commissioner, 

, 461 (2013).

      Respondent has conceded that the partnerships determined the accrued

production costs with reasonable accuracy and that they complied with the

economic performance requirement. However, respondent contends that the

accrued production costs consisted of bilateral contracts for goods and services to

recondition the partnerships’ manufacturing facilities that were provided to and

paid for by the partnerships after the December 31 close of their tax year.

Respondent argues that all events had not occurred during the years in issue to

establish the fact of the liabilities for the accrued production costs. The
                                        - 16 -

[*16] partnerships contend that respondent’s focus on the bilateral goods and

services contracts is misplaced. Instead the partnerships argue that their credit

agreements and multiyear contracts to supply customers with tomato products

obligated them to incur the accrued production costs to restore, rebuild, and retest

the manufacturing facilities. We agree with respondent.

      We have long held that obligations created by separate contracts, statutes, or

regulations may qualify as deductible liabilities for Federal income tax purposes.

Exxon Mobil Corp. v. Commissioner, 

, 318-319 (2000) (hydrocarbon

leases); Ohio River Collieries Co. v. Commissioner, 

, 1370-1371

(1981) (State statute). In such cases the contracts and statutes must clearly set

forth the taxpayer’s obligations so as to “provide a sufficiently fixed and definite

basis on which to base the tax accruals sought”. Exxon Mobil Corp. v.

Commissioner, 

(concluding hydrocarbon lease that did not

clearly set forth and establish taxpayer’s obligations failed to meet first prong of

all events test); see also Ohio River Collieries Co. v. 

, 1375-1376 (ruling Ohio’s comprehensive strip-mining reclamation statute

that detailed requirements for refilling, grading, resoiling, and planting mined

areas established fact of liability).
                                         - 17 -

[*17] The credit agreements involved in these cases do not specifically set forth

the partnerships’ obligations to provide a comparably sufficiently fixed and

definite basis. Instead the credit agreements include nonspecific text and

generalized obligations. The agreements merely require that the partnerships

“maintain all material licenses, Permits, [and] governmental approvals”, comply

with “all laws”, and “keep all property useful and necessary in its business in good

working order and condition”. The credit agreements neither specify which laws

or regulations must be complied with nor identify exactly which property must be

kept in good working order. Accordingly, we conclude that the generalized

obligations found in the credit agreements do not establish the fact of the

partnerships’ liabilities for the accrued production costs for the years in issue.

      The partnerships alternatively assert that their multiyear production

contracts with various customers establish the fact of their liabilities for the

accrued production costs. While these production contracts involve extensive

product quality specifications, the partnerships’ efforts to comply with their

customers’ specifications are production-run specific. Such compliance

necessarily takes place before and during the production run of tomato products

for a given customer. The accrued production costs in issue were for goods and

services provided after the production run in each year in issue. Furthermore, the
                                         - 18 -

[*18] parties have stipulated that the accrued production costs in issue are to

restore, rebuild, and retest the manufacturing facilities for use during the next

production cycle. We conclude that the partnerships’ multiyear production

contracts fail to establish the fact of the liabilities for the accrued production costs

for the years in issue.

      Because of our holding that the liabilities for the accrued production costs

were not fixed in the years in issue, we need not address the partnerships’

arguments regarding the recurring items exception under section 461(h).

      We have considered all of the parties’ arguments, and, to the extent not

addressed above, we conclude that they are moot, irrelevant, or without merit. To

reflect the foregoing, the stipulation of settled issues, and the modifications of

adjustments conceded in respondent’s briefs,


                                                  Decisions will be entered under

                                         Rule 155.