[00:00:06] Speaker 03:
Good morning.

[00:00:07] Speaker 03:
My name is Robert Rubin, and I represent the appellants.

[00:00:12] Speaker 03:
And may I reserve two minutes for rebuttal?

[00:00:18] Speaker 03:
Thank you.

[00:00:22] Speaker 03:
This case involves an inventory method of accounting and the recurring item exception to the economic performance test.

[00:00:37] Speaker 03:
The taxpayers have used the same method of accounting since the inception of their business in the 80s.

[00:00:49] Speaker 03:
They were audited twice by IRS.

[00:00:52] Speaker 03:
One time the issue was never raised.

[00:00:55] Speaker 03:
The other time the issue was raised.

[00:00:58] Speaker 03:
And at the IRS Independent Office of Appeals, they approved the method of accounting.

[00:01:05] Speaker 03:
And that's prior audit evidence that the tax court excluded.

[00:01:10] Speaker 03:
It should have been admitted, especially considering the IRS approval of this method of accounting at IRS appeals.

[00:01:20] Speaker 03:
And the cases discussing the relevancy of that evidence are in our briefs.

[00:01:27] Speaker 04:
Can you answer one question I've always had?

[00:01:29] Speaker 04:
Why does it matter?

[00:01:30] Speaker 04:
Why does it matter whether or not the reconditioning costs are applied in year A or year B?

[00:01:35] Speaker 04:
It seems like at the end of the day, you're going to pay the same amount.

[00:01:39] Speaker 03:
Well, by deducting them in year A, you reduce taxable income in year A.

[00:01:50] Speaker 03:
And yes, over the entire history of the business, it equals out.

[00:01:56] Speaker 03:
But the adjustments in the first year here, 2008, result in about a $5 million tax liability for the taxpayers.

[00:02:07] Speaker 03:
Got it.

[00:02:10] Speaker 03:
So the recurring item exception to the economic profile.

[00:02:12] Speaker 01:
I'm sorry.

[00:02:12] Speaker 01:
Can I just follow up on that?

[00:02:13] Speaker 01:
So sorry.

[00:02:14] Speaker 01:
Is that just because of the slice of time that the IRS chose

[00:02:19] Speaker 01:
go back to.

[00:02:20] Speaker 01:
I mean I don't really understand why over time if you just kept doing this it would change the amount owed.

[00:02:25] Speaker 03:
Well over time it wouldn't but in 2008 there were huge adjustments to cost of goods sold which increased taxable income which increased the tax liability of the partners.

[00:02:41] Speaker 03:
And it's just that.

[00:02:42] Speaker 01:
But if they had started the year before that, it would have been accounted the year before that, right?

[00:02:47] Speaker 01:
It's because of the particular years chosen that this happened, right?

[00:02:51] Speaker 03:
Well, it's because of the size of the taxpayer.

[00:02:54] Speaker 03:
We're talking about $20 million adjustment to cost of goods sold, moving it from year one to year two.

[00:03:02] Speaker 03:
That results in a tremendous amount of increased income in year one.

[00:03:07] Speaker 03:
And it's because of the size of the taxpayer, the dollars involved.

[00:03:13] Speaker 04:
The bottom line is, under either method of accounting, you're going to pay the same amount long term.

[00:03:19] Speaker 04:
It's just what's owed immediately.

[00:03:21] Speaker 03:
Correct.

[00:03:23] Speaker 04:
So my own understanding was always that the taxpayer has some deference on which way to make the accounting as long as the method clearly reflects income.

[00:03:33] Speaker 03:
Well, that is correct.

[00:03:34] Speaker 03:
And it's especially true for inventory accounting.

[00:03:37] Speaker 03:
The regulations say that it's based on the experience and custom in the industry, and also that consistency is the greatest, greater factor, is what the regs say.

[00:03:52] Speaker 01:
So consistency.

[00:03:55] Speaker 01:
It goes to whether the method of accounting reflects income.

[00:03:58] Speaker 01:
But I thought that was a different issue than whether the method results in a more proper match against income.

[00:04:04] Speaker 01:
I know those sound really similar, but are there different concepts?

[00:04:07] Speaker 03:
Well, yes, because in the recurring item exception, in order to use it, the method used by the taxpayer must result in a more clear match of income and expenses.

[00:04:22] Speaker 03:
And so we've got these tomato processing facilities that run flat out for 100 days in the summer basically.

[00:04:33] Speaker 03:
They're inoperable.

[00:04:36] Speaker 03:
That's stipulated.

[00:04:37] Speaker 03:
They're inoperable when the plant's shut down.

[00:04:39] Speaker 03:
And all this $20 million of work needs to be done before... I have a question about that, Council.

[00:04:46] Speaker 00:
The security agreements have an exception for ordinary wear and tear.

[00:04:54] Speaker 00:
And contextually,

[00:04:57] Speaker 00:
Even though the machinery is in lousy shape at the end of the season, because it's used 24-7, everybody knew that at the outset.

[00:05:07] Speaker 00:
And given this context, why isn't that ordinary wear and tear, as opposed to, say, a part that breaks or a fire destroys something or something like that?

[00:05:17] Speaker 00:
Why isn't that, in this situation, ordinary wear and tear?

[00:05:22] Speaker 00:
looking at New York law which weirdly these contracts tell us to apply.

[00:05:27] Speaker 03:
So ordinary wear and tear means that the plant is still operable.

[00:05:35] Speaker 00:
Why is that true?

[00:05:38] Speaker 00:
It is whatever results from the use that the parties expect.

[00:05:44] Speaker 03:
But no one could step in and operate the plants after they were shut down.

[00:05:49] Speaker 01:
I don't really understand that though because I mean are you saying that at the end of the summer if one more truck of tomatoes arrived you couldn't process it?

[00:05:58] Speaker 03:
That's correct.

[00:06:00] Speaker 01:
How is that possible?

[00:06:01] Speaker 03:
Well you would first of all if you shut the plants down you would lose sterility.

[00:06:05] Speaker 01:
Right I understand that but doesn't that go to you have to sterilize before the next season?

[00:06:10] Speaker 01:
It doesn't really mean they're inoperable in September or whatever the time is.

[00:06:14] Speaker 03:
It's stipulated that they're inoperable.

[00:06:17] Speaker 01:
There's a stipulation that unless this work is done... But for the next season, not if one more truck arrives in September, right?

[00:06:25] Speaker 03:
Well, it would be uneconomic to re-sterilize the plant for one more truck of tomatoes.

[00:06:33] Speaker 00:
That's not the question.

[00:06:35] Speaker 00:
The question, I think, if I understand it correctly, is does the machinery become inoperable because you turn it off and stop producing, or does it become inoperable because you've reached the last possible tomato and the machine says, I give up?

[00:06:57] Speaker 00:
It's it's inoperable because it's been run flat out for 100 days You've got these big boilers that doesn't answer my question Is it physically inoperable or is it inoperable because you turn it off and then have to go through a lot of?

[00:07:13] Speaker 00:
Tremendous work to get it restarted for the next time if the question is

[00:07:21] Speaker 03:
Could they have processed another truckload of tomatoes?

[00:07:24] Speaker 03:
Had they not shut it down?

[00:07:25] Speaker 03:
Yes, they could have.

[00:07:27] Speaker 01:
OK.

[00:07:27] Speaker 01:
And so doesn't that show that really the repair is to do the next season?

[00:07:32] Speaker 01:
I mean, it is to do the next seasons of work, right?

[00:07:35] Speaker 01:
You need to sterilize it so that you can start the next season's tomatoes.

[00:07:39] Speaker 03:
Well, yes.

[00:07:41] Speaker 03:
But you also need to do the work to repair the damage that was done during the current year

[00:07:49] Speaker 03:
And the legislative history of the recurring item exception talks about matching expenses with income.

[00:07:58] Speaker 03:
It talks about a sale is made in year one, but the commission isn't paid until year two, or the shipping costs aren't paid until year two.

[00:08:09] Speaker 03:
Under the recurring item exception, you should match those expenses with the sale revenue recognized in year one.

[00:08:18] Speaker 03:
And our method allocates.

[00:08:20] Speaker 03:
We're not taking all the repair costs in year one.

[00:08:23] Speaker 03:
We take that percentage of the repair costs that is equal to the current year's production that was sold in year one.

[00:08:30] Speaker 03:
It's really a perfect match of income and expenses.

[00:08:34] Speaker 01:
So you have this argument that it would be in violation of the loan agreements if you didn't do these repairs.

[00:08:41] Speaker 01:
And so this is partly why there's this obligation.

[00:08:45] Speaker 01:
You don't actually do the repairs until the next spring.

[00:08:48] Speaker 01:
So are you in breach of the loan agreement all the way from fall to spring?

[00:08:53] Speaker 03:
Well, you're certainly in breach of it if you don't do the work in the spring.

[00:08:58] Speaker 01:
But OK, but so are you in breach of it in January?

[00:09:05] Speaker 03:
It's debatable.

[00:09:07] Speaker 01:
I guess because it seems like your argument suggests you're in breach of the agreement most of the time, I have trouble telling why it helps you show that the expense goes in the fall versus the spring.

[00:09:17] Speaker 01:
I mean, if you're just in breach a lot of the time, then how does it tell us where you should put the money?

[00:09:23] Speaker 03:
It's not that it's in breach of the agreement the day after you shut down, but it's the loan agreements

[00:09:32] Speaker 03:
that create the absolute liability that that work has to be done.

[00:09:36] Speaker 03:
The loan agreements don't say when it has to be done, but it does have to be done.

[00:09:41] Speaker 03:
And that's the absolute liability.

[00:09:44] Speaker 01:
So partly this gets back to Judge Graber's question, though.

[00:09:46] Speaker 01:
So the loan agreements allow you to have normal wear and tear.

[00:09:50] Speaker 01:
And everyone knows, I think, that over the course of use, there's going to be this need for further work.

[00:09:55] Speaker 01:
But part of the work is sterilization, too, right?

[00:10:00] Speaker 01:
If the lender had to repossess this equipment and move it somewhere, it would not be sterile anymore, would it?

[00:10:07] Speaker 03:
No.

[00:10:07] Speaker 03:
But the lender, let's say there was a default on the loans.

[00:10:12] Speaker 03:
They weren't being paid.

[00:10:14] Speaker 03:
The lender would require this work to be done by the borrower before.

[00:10:18] Speaker 01:
I mean, it wouldn't make sense to make them sterilize it if they had to move it somewhere else and then be sterilized again, right?

[00:10:23] Speaker 03:
That's correct.

[00:10:23] Speaker 01:
So a lot of this work wouldn't have to be done under the loan agreement?

[00:10:26] Speaker 03:
Well, the sterilization isn't that

[00:10:29] Speaker 03:
much of the work that needs to be done.

[00:10:32] Speaker 01:
Do we have a breakdown of that?

[00:10:33] Speaker 03:
Yes.

[00:10:35] Speaker 03:
It's... Excerpt of records, it starts on 428, goes through 430, and there's very detailed

[00:10:52] Speaker 03:
description of the work that's done, including labor, boiler fuel, electricity, waste disposal, chemicals, lubrication, production supplies, repairs and maintenance.

[00:11:07] Speaker 03:
All of this, by the way, was stipulated by IRS.

[00:11:10] Speaker 03:
So they wouldn't have stipulated that $70 million of work had been done if the taxpayer had not substantiated

[00:11:20] Speaker 03:
the work that was done.

[00:11:21] Speaker 01:
I think everyone agrees the work is done.

[00:11:23] Speaker 01:
The question is just when is it best matched income and when is there this obligation under the loan agreement or not.

[00:11:31] Speaker 03:
Well, they produce tomatoes.

[00:11:34] Speaker 03:
It's done in October.

[00:11:36] Speaker 03:
50% of them are sold before the end of the year under the taxpayers method of accounting, which they've consistently used, was approved by IRS.

[00:11:45] Speaker 03:
They allocate 50%.

[00:11:46] Speaker 04:
Do you know why the IRS changes position on this?

[00:11:51] Speaker 04:
No.

[00:11:54] Speaker 04:
Have they done it across the board among other, you probably might be in a unique industry.

[00:12:00] Speaker 04:
I don't know if they've done this across other tomato pasters.

[00:12:04] Speaker 03:
I'm not aware of that, but I can tell you that as far as I know, this is a unique situation because most tomato processors are C corporations and can elect a June 30 fiscal or taxable year.

[00:12:21] Speaker 03:
because these are taxes partnerships they can't.

[00:12:23] Speaker 03:
That's what causes the problem here.

[00:12:26] Speaker 04:
Can I ask a follow up to Judge Freeland's question about if in January the loan said that you're in default, isn't the answer is yes you're in default but then you have time to cure it at that point and the practice among the parties in this particular case is not to call for a default in January, it'd be closer to June or that's April I think is when

[00:12:49] Speaker 03:
It's not in the record, but there's never been a default declared by the lenders.

[00:12:54] Speaker 03:
But this work has been done every year.

[00:12:57] Speaker 04:
It's just a party practice, right?

[00:12:59] Speaker 04:
Yes.

[00:13:04] Speaker 01:
You want to save your time for rebuttals?

[00:13:05] Speaker 03:
Please.

[00:13:07] Speaker 03:
Thank you.

[00:13:19] Speaker 02:
Good morning.

[00:13:20] Speaker 02:
May it please the court.

[00:13:21] Speaker 02:
I'm Anthony Sheehan, and I represent the Commissioner of Internal Revenue.

[00:13:25] Speaker 02:
The court started out today talking about timing.

[00:13:29] Speaker 02:
And timing does matter.

[00:13:30] Speaker 02:
You see the big adjustments here.

[00:13:32] Speaker 02:
You see that many investors will try to coordinate the sale of gaining and losing securities.

[00:13:40] Speaker 02:
And a lot of the early 80s tax shelters were based on timing.

[00:13:46] Speaker 01:
But is there any reason to think that's happening here?

[00:13:48] Speaker 01:
I mean, I thought it was clear that they had been doing the same thing all the time.

[00:13:52] Speaker 01:
And if they're doing the same thing all the time, the income is coming sometime.

[00:13:55] Speaker 01:
You're going to get the taxes sometime.

[00:13:56] Speaker 01:
I don't understand why all of a sudden you're pursuing this case or why you're starting in the year where you're starting.

[00:14:03] Speaker 02:
We were pursuing this case because the IRS conducted an audit and decided that this method of first of all that this taxpayer did not meet the all events test.

[00:14:14] Speaker 02:
And that's the first test that must be met.

[00:14:16] Speaker 02:
under this court's law challenge publication, you've got to beat the all events test.

[00:14:21] Speaker 02:
And then secondarily, that this was not a good match.

[00:14:25] Speaker 02:
And the commissioner has broad discretion to determine that the match being used, the method of accounting being used, and matching is part of method of accounting to determine whether it would clearly reflect income.

[00:14:35] Speaker 02:
But wasn't there another audit previously, and this was blessed?

[00:14:39] Speaker 02:
There was another audit previously, but to say it was blessed, I think, is a great exaggeration.

[00:14:44] Speaker 02:
Those audits ended in no change letters.

[00:14:46] Speaker 04:
Correct.

[00:14:47] Speaker 02:
The no change letters means.

[00:14:48] Speaker 04:
So did the IRS know about this method of accounting in the first audit?

[00:14:53] Speaker 02:
Well, the first audit was of, one of the audits was of Morningstar, and all we have in the record is a no change letter.

[00:14:59] Speaker 02:
The second audit was of a company that.

[00:15:01] Speaker 04:
But presumably the IRS did a good job in auditing the first time, and they would have known how they made their accounting, correct?

[00:15:09] Speaker 04:
Presumably they did do a good job in auditing, but each time.

[00:15:12] Speaker 04:
And then that led to no change.

[00:15:14] Speaker 04:
So a good inference is that they blessed it.

[00:15:17] Speaker 02:
Well, a no change letter simply means that they didn't disallow it.

[00:15:22] Speaker 02:
Which means they blessed it.

[00:15:24] Speaker 02:
But it does not make any promises, it does not make any commitments, it does not make any assurances.

[00:15:29] Speaker 04:
But there's a stopple, correct?

[00:15:30] Speaker 04:
Like there's reliance interest that for 20 years they've been doing it the same way, you've been blessed once.

[00:15:36] Speaker 04:
That's why it's just kind of surprising all of a sudden out of the blue, IRS is saying, no, you can't do this.

[00:15:41] Speaker 02:
Well, the all events test is a legal test.

[00:15:43] Speaker 04:
And did it change over the last audit?

[00:15:48] Speaker 02:
The all-events test has been constant, but it's a legal test.

[00:15:51] Speaker 02:
And the commissioner cannot be stopped on a legal test, nor can the commissioner be stopped.

[00:15:56] Speaker 04:
But was there a change in the all-events test between this audit and the first audit?

[00:16:00] Speaker 02:
No, the all-events test has been pretty consistent.

[00:16:03] Speaker 00:
So the question I have is, if the IRS made a legal error in its earlier audit,

[00:16:12] Speaker 00:
Is it bound to continue that odd, infinite item?

[00:16:15] Speaker 02:
No, it is not.

[00:16:17] Speaker 02:
And in terms of audits, things change over time.

[00:16:22] Speaker 02:
You've got difference in enforcement priorities, difference in resources.

[00:16:28] Speaker 02:
An item which may be a small item on a return one year may grow to be a big item.

[00:16:33] Speaker 02:
And a future auditor may look at it and decide, we need to fix this.

[00:16:39] Speaker 02:
I just really have trouble.

[00:16:41] Speaker 01:
I mean, I think you may have really good legal arguments on all the points, but I'm just really struggling with why you've bothered to do this case.

[00:16:47] Speaker 01:
Because you may have good arguments that the 2008 money should have been paid in 2007, but they're going to pay it in 2009 or eight.

[00:16:55] Speaker 01:
I mean, it's going to get paid.

[00:16:56] Speaker 01:
No one is saying they're not paying or doing this work.

[00:16:58] Speaker 01:
So I just really don't understand why this is a priority or what's going on here.

[00:17:04] Speaker 02:
The IRS audited this and the case went forward.

[00:17:09] Speaker 00:
It seems to me financially it could make a difference at the end because if they're not actually required by contract to perform the next spring's repair and cleanup, whatever we want to call that, and they simply stop, I'm not sure it does come out the same way.

[00:17:34] Speaker 02:
Two things I was actually going to get to, Your Honor.

[00:17:37] Speaker 02:
One of which is that if a taxpayer is consistently doing it wrong, you could say that, well, at the end of time, it'll all even out.

[00:17:47] Speaker 02:
But oftentimes, as we saw with a lot of the early 80s shelters, that last year, that last balloon of tax liability doesn't get reported.

[00:17:55] Speaker 02:
Or if it does get reported, the taxpayer says, well, I don't have the money anymore.

[00:18:00] Speaker 02:
I can't pay it.

[00:18:02] Speaker 02:
basically is taking an interest-free loan from the government and hoping and putting the risk on the government that at the end of time, the money will be there.

[00:18:10] Speaker 02:
Interest-free loan?

[00:18:11] Speaker 04:
It's their money that they're giving to you.

[00:18:12] Speaker 02:
I don't understand that.

[00:18:15] Speaker 02:
If you're doing an improper matching and shifting your tax liability forward, forward, and forward, that means that each year you're paying less taxes.

[00:18:23] Speaker 04:
That's just a philosophical difference I think we have.

[00:18:26] Speaker 02:
Yes, Your Honor.

[00:18:27] Speaker 02:
And secondly, if a taxpayer does want clarity and does want assurance,

[00:18:31] Speaker 02:
The IRS has programs for that.

[00:18:33] Speaker 04:
Yeah, but isn't going through an audit and being given no change kind of a surety and all the insurance you need?

[00:18:42] Speaker 02:
No, it is not.

[00:18:43] Speaker 02:
It just means for that year.

[00:18:44] Speaker 04:
Isn't it also true that IRS has blessed this for other tomato processors as well?

[00:18:51] Speaker 02:
In the record, the other audit was of a related company that's now defunct.

[00:18:58] Speaker 02:
It did go up to appeals, but it still resulted in a no-change letter, a letter just saying, for these years, we are not changing anything on your return.

[00:19:07] Speaker 04:
That's not in the- So it just really seems like you're singling them out for some reason.

[00:19:13] Speaker 02:
Well, right now, we have to decide what's the correct result in this case on these facts before us.

[00:19:19] Speaker 02:
I mean, all audits involve a selection process.

[00:19:22] Speaker 02:
And it's a standard thing in the tax court.

[00:19:24] Speaker 02:
We don't look behind the notice of deficiency.

[00:19:26] Speaker 02:
We don't look behind the FPAW.

[00:19:28] Speaker 02:
we decide what is the correct application of a tax law to this item on these facts.

[00:19:36] Speaker 00:
What is the precise effect of a no change letter, the legal effect of that?

[00:19:43] Speaker 02:
The legal effect is that for this particular tax year under audit, we have not changed your return.

[00:19:54] Speaker 04:
But you're not penalizing them in any way, correct?

[00:19:58] Speaker 02:
For some adjustments that were conceded, I think there is a penalty, but that's off the table now.

[00:20:07] Speaker 02:
For these adjustments, there is no penalty.

[00:20:09] Speaker 02:
It is just simply the adjustments.

[00:20:11] Speaker 04:
It just seems like a difference in accounting.

[00:20:14] Speaker 02:
Just a difference in accounting for these particular adjustments.

[00:20:18] Speaker 02:
Am I wrong?

[00:20:18] Speaker 04:
I thought usually we give deference to the taxpayer on how to adjust as long as their accounting method clearly reflects income.

[00:20:26] Speaker 02:
Well, the deference would be really in the question you asked, Your Honor, it has to clearly reflect income.

[00:20:35] Speaker 02:
If it doesn't clearly reflect income, if it does, if it, look at the cases which my opponent cited in his brief, you had one

[00:20:43] Speaker 02:
involving fees and storage for liquor barrels.

[00:20:46] Speaker 02:
There was a battle of the experts, and it was determined a clearly reflected income.

[00:20:51] Speaker 02:
In the New Hampshire public utilities case, the taxpayer was using a method

[00:20:56] Speaker 02:
that was industry standard and had been accepted by the IRS.

[00:21:01] Speaker 02:
The IRS has broad discretion to change a method of accounting that does not clearly reflect income.

[00:21:08] Speaker 02:
But if it does already clearly reflect income, we don't get into debates about what reflects income even more.

[00:21:14] Speaker 04:
And in this case, we know income is going to be reflected.

[00:21:16] Speaker 04:
It's just a matter of either A or B, correct?

[00:21:20] Speaker 02:
Right.

[00:21:20] Speaker 02:
And if you look at the stipulation of facts.

[00:21:23] Speaker 04:
So it just seems like, I don't know,

[00:21:25] Speaker 04:
It's just kind of subjective and you're just saying mine is better and yours is not.

[00:21:29] Speaker 02:
Well, again, if you look at the stipulation of facts, page 1241, the costs at issue are costs to restore, rebuild, and retest the manufacturing facilities for use during the next production cycle.

[00:21:46] Speaker 02:
If the companies were to shut down, they would not be reconditioning these.

[00:21:51] Speaker 02:
Every supply contract has a clause in it for a short crop.

[00:21:55] Speaker 02:
In other words, if something happens with the tomatoes, and let's say there's only going to have half a crop this year, Morningstar and Liberty can invoke that clause to reduce the amount of paste they have to supply.

[00:22:09] Speaker 02:
And they've got three production lines.

[00:22:10] Speaker 02:
If they figure out they can process those tomatoes with two, the question then becomes, are they going to spend the millions of dollars, and they've emphasized how expensive this is,

[00:22:20] Speaker 02:
to recondition these production, all three production lines when they can get by with two.

[00:22:25] Speaker 02:
So long as the customers get the tomato paste commensurate with the tomatoes available, they're not going to ask for the third one.

[00:22:34] Speaker 02:
And it seems to be odd that the bank, who wants to protect its collateral and get repaid, would say to them, well, sorry, but even though you're not going to use that line this year,

[00:22:47] Speaker 02:
Please go ahead and spend millions of dollars you may not have to recondition it.

[00:22:51] Speaker 00:
I want to ask you one more question just to be sure I understand your position.

[00:22:59] Speaker 00:
Your difference of view on the accounting system, it sounds like your argument isn't this is just a difference of view.

[00:23:07] Speaker 00:
Your argument, as I understand it, is that under the legal standard that applies on the all events test, they are not entitled as a matter of law.

[00:23:17] Speaker 00:
to what they've done.

[00:23:18] Speaker 00:
Is that correct?

[00:23:19] Speaker 02:
That is correct.

[00:23:20] Speaker 02:
And that's what the tax court said and stopped.

[00:23:22] Speaker 02:
Matching is a separate question.

[00:23:24] Speaker 02:
The tax court went ahead and looked at the evidence and said, taxpayer has not shown that the all events test was met, so that this liability is fixed in year A, in the first year.

[00:23:37] Speaker 04:
Do you agree that the reconditioning cost is ordinary wear and tear?

[00:23:46] Speaker 02:
the under new york law which is what applies here if i understand correctly will certainly processing tomatoes all out for several months imposes wear and tear on this equipment but after you think we can get the twenty million dollars in the conditioning fees that's not wear and tear

[00:24:11] Speaker 02:
I'm trying to make sure I understand your question correctly.

[00:24:14] Speaker 01:
I'm surprised you're hesitating, because I thought this was definitely your position.

[00:24:17] Speaker 01:
I thought your position was that it was wear and tear, and that's why it's not a breach of the contract.

[00:24:22] Speaker 01:
Isn't that what you argued?

[00:24:23] Speaker 02:
Yeah, it is wear and tear.

[00:24:25] Speaker 01:
How can that be?

[00:24:26] Speaker 04:
$20 million is wear and tear?

[00:24:30] Speaker 02:
Well, the cost of, let's put it this way,

[00:24:40] Speaker 02:
The question is, what does the bank want?

[00:24:43] Speaker 02:
What does the bank want for this equipment?

[00:24:45] Speaker 02:
The equipment includes things like pumps.

[00:24:47] Speaker 04:
Wear and tear would mean, like, they recondition it all the time.

[00:24:49] Speaker 04:
And you know, things get loose, things get old.

[00:24:51] Speaker 04:
That's wear and tear.

[00:24:52] Speaker 04:
But if they did not recondition it at all, that's much more than wear and tear.

[00:24:56] Speaker 04:
That's destruction of the equipment.

[00:24:59] Speaker 04:
You would agree?

[00:24:59] Speaker 02:
Well, after the processing ends in year A, yes, they do have to do cleaning.

[00:25:03] Speaker 02:
They've got to clean out the residue.

[00:25:05] Speaker 02:
They've got to prepare this equipment for the hiatus.

[00:25:07] Speaker 04:
That's all allowed in year A.

[00:25:09] Speaker 04:
So what happens to the equipment if they continue to use the processing for five years without reconditioning?

[00:25:16] Speaker 02:
If they continue continuously for five years, I don't think the equipment could handle it.

[00:25:19] Speaker 04:
And so that's breaking the equipment.

[00:25:22] Speaker 04:
That's not ordinary wear and tear, correct?

[00:25:25] Speaker 02:
Five years straight, flat out, no breaks.

[00:25:28] Speaker 02:
That's probably abuse of the equipment.

[00:25:29] Speaker 02:
Yeah, exactly.

[00:25:30] Speaker 02:
Right.

[00:25:31] Speaker 02:
But the reconditioning.

[00:25:32] Speaker 04:
So therefore, reconditioning is a necessary part of using the machine so that it's not wear and tear.

[00:25:37] Speaker 02:
The reconditioning is necessary so that you can do the processing in year B. That's why it is a forward-looking thing into year B. Why is that the case?

[00:25:49] Speaker 04:
Because in year zero, the equipment comes in brand new, right?

[00:25:53] Speaker 04:
And then they process tomatoes at the end of year A. Why wouldn't it be proper to restore it back to the proper working condition at the end of year A?

[00:26:05] Speaker 02:
They do have to restore it if they want to process it, but they're restoring it so they can process.

[00:26:10] Speaker 02:
If they ended year A and decided this tomato thing's not going to work out, they're not going to recondition it.

[00:26:16] Speaker 04:
And the question- Sure, but under Gold Coast, we don't really consider those random contingencies.

[00:26:22] Speaker 04:
Well, the question is, at what point- They're going to spend how many millions of dollars on this equipment?

[00:26:26] Speaker 04:
They're going to stop it after one year and just say, eh.

[00:26:30] Speaker 02:
if it didn't work.

[00:26:33] Speaker 02:
Fortunately for them, it didn't.

[00:26:34] Speaker 04:
It's unrealistic.

[00:26:35] Speaker 04:
On a Gold Coast, don't we say we look at what's actually reasonable and reasonably foreseeable, and the fact that they're just going to stop processing tomatoes after spending all this money is pretty unreasonable?

[00:26:45] Speaker 02:
Well, in Gold Coast, the point there is that at 1,200 slop club points, this liability is fixed.

[00:26:54] Speaker 02:
You know you're going to have to pay the reward.

[00:26:55] Speaker 02:
The technicality of somebody claiming it

[00:26:58] Speaker 04:
And then we said that even if the casino shut down, if there was a fire that caused the casino to shut down, we said even under those random contingencies that that cost is already fixed.

[00:27:09] Speaker 02:
Yes, but here their argument is that in October of year A, because of the bank financing and supply agreements, it is absolutely fixed.

[00:27:17] Speaker 02:
We are going to have to go in in June no matter what, no matter if a blight wakes up all the tomatoes.

[00:27:22] Speaker 02:
We're going to have to go in there and recondition this equipment to the point where we can process tomatoes again, spend millions of dollars even if it's going to continue to lie fallow.

[00:27:33] Speaker 02:
Our point is that you don't

[00:27:36] Speaker 02:
That does not happen in year A. The very fact of the practice of it that the equipment's not reconditioned until year B, and then it's reconditioned in anticipation of the next production cycle, is where you get that fixed liability when they decide, yes, indeed, the harvest is looking good.

[00:27:56] Speaker 02:
Heck, the farmers aren't even buying tomato seeds until December.

[00:27:59] Speaker 02:
The harvest is looking good.

[00:28:00] Speaker 02:
The tomatoes are coming in.

[00:28:02] Speaker 02:
We need all three lines.

[00:28:03] Speaker 02:
We need to get them ready and put them in shape.

[00:28:06] Speaker 02:
to put them in shape to process these new tomatoes coming in.

[00:28:12] Speaker 02:
That, as the tax court once described in the case, is the heart of the transaction.

[00:28:17] Speaker 02:
That is the thing that that decision is what fixes the liability.

[00:28:24] Speaker 02:
And looking at the banks, they've yet to establish the banks are saying, we want fully reconditioned equipment, as opposed to we want things we can sell for collateral.

[00:28:35] Speaker 02:
And I see my time's up.

[00:28:36] Speaker 02:
So unless there are any further questions, I thank the court for its time in asking to affirm.

[00:28:41] Speaker 01:
Thank you.

[00:28:42] Speaker 01:
We have some time for rebuttal.

[00:28:48] Speaker 03:
So Judge Graber, the question about the last year, there's a safety valve in the recurring item exception.

[00:28:57] Speaker 03:
If these funds aren't expended within eight and a half months of the end of the taxable year, they cannot be accrued.

[00:29:05] Speaker 03:
So that's the safety valve that actually overrules Gold Coast.

[00:29:10] Speaker 03:
The recurring item exception was effective for taxable years beginning after 1231.91.

[00:29:15] Speaker 03:
Gold Coast was before that.

[00:29:19] Speaker 03:
If the slot points weren't redeemed within eight and a half months of the end of the taxable year, they're not going to be deductible.

[00:29:25] Speaker 03:
So there's a big safety valve in the recurring item exception.

[00:29:31] Speaker 03:
So appeals does not issue no change letters.

[00:29:37] Speaker 03:
Right?

[00:29:38] Speaker 03:
Examination raised this issue, disallowed the accrual, the taxpayer filed a protest, went to appeals.

[00:29:45] Speaker 03:
We've got a letter from an appeals officer saying, I don't think you're entitled to accrue that.

[00:29:51] Speaker 03:
But ultimately, and what happened, the appeals officer talked to the supervisor, and they conceded the issue.

[00:30:01] Speaker 01:
But there's no law that says that binds the IRS.

[00:30:03] Speaker 03:
Oh, no, no, no.

[00:30:04] Speaker 03:
There's no estoppel.

[00:30:05] Speaker 03:
We never argued there was estoppel.

[00:30:06] Speaker 03:
We're just saying it's a factor that should be considered.

[00:30:10] Speaker 01:
But none of that goes to the all-events test, right?

[00:30:13] Speaker 01:
You have to pass the all-events test first.

[00:30:14] Speaker 03:
Yes, absolutely.

[00:30:17] Speaker 03:
The match, the government's position, there's no match.

[00:30:22] Speaker 03:
It all gets allocated to the next year

[00:30:28] Speaker 03:
The taxpayers method is actually a very technically elegant method of allocating these expenses between current year sales and next year sales.

[00:30:38] Speaker 03:
And in the all events test, there's an absolute liability in these contracts to do that work.

[00:30:45] Speaker 03:
If that work isn't done and it impairs the lenders, for sure they're going to enforce that.

[00:30:51] Speaker 03:
And that's the absolute liability.

[00:30:54] Speaker 03:
The eight and a half month rule in the recurring item exception is the government safety valve.

[00:30:58] Speaker 03:
If the work isn't done, then you can't accrue anything.

[00:31:05] Speaker 01:
You're out of time, so if you could wrap up, that would be great.

[00:31:07] Speaker 03:
All right.

[00:31:08] Speaker 03:
Thank you very much.

[00:31:09] Speaker 01:
Thank you both sides for the helpful arguments.

[00:31:11] Speaker 01:
This case is submitted.