Question

An accrual basis taxpayer, Mega Motors Company, had one of its trucks leave the road and hit a small child playing on the sidewalk. In year 1, Mega settled with the parents and agreed to pay $50,000 each year for 40 years. An accrual basis taxpayer is subject to the all events test for deductions which is satisfied when all events have occurred to fix the taxpayer’s liability and the amount can be determined with reasonable accuracy. The all events test will not be satisfied until “economic performance” has occurred. Assume Mega is in the 35% marginal rate and can earn an 8% after-tax return on its money. What would be the economic effect if only the all events test applied without the requirement of economic performance?”

Answer 1

Sec 461(h)3 states for the exception as to when economic performance occurs for all test events in case of RECURRING ITEMS. Therefore if item qualifies the other two conditions of all test events then amount is deductible for tax purposes.

Hence, Mega Motor company will be allowed for expense of recurring item of $50000.

Economic effect will be reduction in tax liability by 35% of recurring item and subsequently increasing net income. On increased income , after tax 8% return can be earned.

Total economic effect

Reducing tax expense/ increase in net income=50000×35%=17500

Add: return on increased income=17500×8%=1400

Total economic effect=18900