                          T.C. Memo. 2005-225



                        UNITED STATES TAX COURT



         DENIS H. DIEKER, JR., AND SHIRLEY J. DIEKER, ET AL.,1
                             Petitioners v.
              COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 127-04, 128-04,       Filed September 28, 2005.
                 130-04.


     Jack D. Flesher, Gregory L. Franken, and Gregg C. Goodwin,

for petitioners.

     Ann L. Darnold, for respondent.



                          MEMORANDUM OPINION


     GERBER, Chief Judge:     These cases were consolidated for

purposes of trial, briefing, and opinion.       For 1998 and 1999,


     1
      Cases of the following petitioners are consolidated
herewith: John R. Pierce and Sandee Pierce, docket No. 128-04;
Steven A. Nienke and Vickie L. Nienke, docket No. 130-04.
                                - 2 -

respondent determined the following deficiencies in petitioners’

Federal income tax:

                                                  Deficiency

          Petitioners                           1998       1999

Denis H. Dieker, Jr., and Shirley J. Dieker    $3,911    $117,495
John R. Pierce and Sandee Pierce                3,911     117,494
Steven A. Nienke and Vickie L. Nienke          32,921     988,914

After concessions,2 the sole issue for our consideration is

whether a liability claimed through petitioners’ S corporation

met the requirements of the “all-events test” including the

economic performance principles of section 461(h).3

                             Background

     These cases were submitted fully stipulated under Rule 122,

and the stipulated facts are so found.    All petitioners resided

in Kansas at the time their respective petitions were filed.

     Collectively, petitioners own National Contractors, Inc.

(National), an S corporation that operates a construction

business in Wichita, Kansas.    At all pertinent times, National

was owned as follows:




     2
      Petitioners concede the deficiencies for the taxable year
1998 and certain other adjustments to income for the taxable year
1999.
     3
      Unless otherwise indicated, all section references are to
the Internal Revenue Code and all Rule references are to the Tax
Court Rules of Practice and Procedure.
                                 - 3 -



             Shareholder                 Amount

          Steven A. Nienke                60.8%
          Vickie L. Nienke                20.0
          John R. Pierce                   9.6
          Denis H. Dieker, Jr.             9.6
            Total                        100.0

     On or around August 28, 1997, National contracted with

Prairie View Unified School District 362 (the District) to

perform construction work at the Prairie View Middle School and

Performing Arts Center (construction contract) for $8,144,300.

As part of the construction contract, National was required to

obtain a performance bond.   On or around September 5, 1997,

National and Fidelity & Deposit Co. of Maryland (F&D) entered

into a separate agreement for an $8,144,300 performance bond (the

performance bond).   In the event that National failed to complete

the construction work for the project, F&D agreed to act as

surety to the District and was obligated to complete the project.

In addition, in a contemporaneous agreement, petitioners,

National, and Midwest Drywall Co., Inc.4 (collectively the

indemnitors), agreed to indemnify F&D for any costs incurred

under the performance bond (the indemnity agreement).

     On October 22, 1998, the District informed National that it

was terminating its employment, asserting that sufficient cause

existed under the terms of their contract.   At that time, the

     4
      Midwest Drywall Co., Inc., is a company in which
petitioners have an interest.
                              - 4 -

project had not been completed, and the District had paid

National $3,732,732 of the original $8,144,300 contract price.

F&D contracted with Crossland Construction Co. to demolish

defective construction performed by National and to complete the

project in accordance with the specifications under the

construction contract.

     F&D’s counsel and National (through its chairman, petitioner

Steven Nienke) exchanged, during 1999, several letters in an

attempt to resolve the controversy over the parties’ obligations

under the performance bond and the indemnity agreement.   In a

June 30, 1999, letter, F&D’s counsel demanded that the

indemnitors pay $1 million in costs incurred by F&D and notified

National that F&D expected to incur approximately $8 million in

additional costs, without considering any payments that might be

received from the District under the contract.   On July 12, 1999,

National acknowledged that F&D was expecting a $4 million

performance bond loss, but National also asserted defenses that

might obviate its payment of damages.   National (and the other

indemnitors) also proposed to settle any dispute with F&D for $1

million.

     On July 26, 1999, F&D rejected the proposed settlement and

made a counterproposal to settle for $3 million, plus interest

and any additional unpaid losses.   On October 18, 1999, National

acknowledged it had obligations under the parties’ agreement and
                               - 5 -

offered to settle for an initial payment of $500,000 and $25,000

each month thereafter until F&D’s cost to complete the project

had been reimbursed, not to exceed $4 million.    On November 9,

1999, National proposed to settle for $5 million, payable from

1999 through 2001, with incentive credits for early payments.

Also in the November 9, 1999, letter National admitted that its

obligation, at that time, to F&D under the indemnity agreement

and the performance bond was over $2,500,000.    On November 18,

1999, F&D proposed adjustments to the payment plan and incentive

structure, as follows:   payments of $5,250,000 from 1999 to 2001

or $4,750,000 if paid in full on or before July 1, 2000.    As of

December 31, 1999, F&D had incurred over $2,500,000 in its

attempt to complete the construction project.

     On or around June 22, 2000, F&D sued the indemnitors under

the indemnity agreement for $7,296,070, representing the costs

F&D incurred to complete the construction project.    On October 5,

2000, National agreed to pay $4,638,500 to F&D in two

installments, with $2,500,000 to be paid within 2 days after the

agreement was signed and $2,138,500 to be paid on or before

January 15, 2001.   In a separate settlement agreement among

National, the District, and F&D, the District agreed to pay F&D a

portion of the remaining outstanding amount due under the

original construction contract between National and the District.
                               - 6 -

     National timely filed a 1999 Form 1120S, U.S. Income Tax

Return for an S Corporation, using the accrual and percentage-of-

completion methods of accounting.   National claimed a $2 million

reduction of income in the form of cost of goods sold, which

represented the amount owed by National to F&D under the

indemnity agreement.   Thereafter, National filed an amended Form

1120S, claiming an additional $500,000 reduction of gross income,

thereby increasing the reduction to $2,500,000. Petitioners

timely filed their 1999 Federal income tax returns claiming their

proportionate shares of the $2,500,000 reduction of income.

                            Discussion

     The parties agree that as of December 31, 1999, National was

obligated to F&D for the reasonable costs incurred by F&D, as

surety under the performance bond, to complete the construction

project.   The parties also agree that, as of December 31, 1999,

National admitted that it had an obligation to F&D of more than

$2,500,000.   The parties disagree as to whether National’s

obligation, as of December 31, 1999, met the all-events test for

accrual, including the requirements of section 461(h).   To decide

this issue, we must determine, as of December 31, 1999, whether:

(1) The fact of a liability could be determined, (2) the amount

of that liability could be determined with reasonable accuracy,

and (3) economic performance occurred with respect to that

liability.
                                - 7 -

     Generally, the Commissioner’s determinations are presumed

correct, and the taxpayer bears the burden of proving that those

determinations are erroneous.   Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933).   The burden of proof may shift to the

Commissioner under section 7491 in certain circumstances.

Petitioners do not contend and have not established that section

7491(a) applies in this case.   Accordingly, petitioners must show

their entitlement to the claimed deductions.    See Rule 142(a).

     The taxpayer’s method of tax accounting determines the

taxable year for which deductions are proper.    Sec. 461(a).

National elected the accrual method of accounting, which is a

permitted tax accounting method.   Sec. 446(c)(2).   Generally, an

accrual method taxpayer is entitled to a deduction in “the

taxable year in which all the events have occurred that establish

the fact of the liability, the amount of the liability can be

determined with reasonable accuracy, and economic performance has

occurred with respect to the liability.”   Secs. 1.446-

1(c)(1)(ii)(A), 1.461-1(a)(2)(i), Income Tax Regs.; see sec.

461(h)(1), (4); Weaver v. Commissioner, 121 T.C. 273, 276 (2003).

     In their briefs, the parties denominated the disputed

$2,500,000 a “deduction”, in spite of National’s treatment of the

item as “cost of goods sold”.   Cost of goods sold, however, is

used to reduce sales receipts to arrive at gross income; it is
                               - 8 -

not a deduction from gross income.5    See sec. 1.61-3(a), Income

Tax Regs.   Despite this contradiction, under the accrual method,

the economic performance requirement must be met for an item to

be deducted or included in cost of goods sold.    Secs. 1.446-

1(c)(1)(ii)(B), 1.61-3(a), Income Tax Regs.    Accordingly, we look

to whether economic performance has occurred with respect to the

$2,500,000 obligation.6

1.   All-Events Test

      In order for petitioners to be entitled to deduct their

portion of the $2,500,000 passthrough from National, they must

show that the item meets the requirements of the all-events test.

To satisfy that test, they must show (1) that all events have

occurred which determine the fact of a liability and (2) that the

amount of the liability can be determined with reasonable

accuracy.   Sec. 461(h)(4); see Restore, Inc. v. Commissioner,

T.C. Memo. 1997-571, affd. 174 F.3d 203 (11th Cir. 1999); Spitzer

Columbus, Inc. v. Commissioner, T.C. Memo. 1995-397.


      5
      The parties stipulated that National reported the liability
as part of cost of goods sold. Petitioners, however, on brief
contend that the only description of the $2,500,000 item was on
the amended Form 1120S as “PY Accrued Loss on Liability”. The
distinction petitioners make is of no consequence because the
standard for accrual is the same irrespective of whether the item
is a deduction/loss or part of cost of goods sold.
      6
      The parties have not indicated that the amounts of the
redetermined deficiencies will depend upon whether the $2,500,000
item is determined to be a deduction or part of cost of goods
sold. Accordingly, we find it unnecessary to decide that
question.
                               - 9 -

     a.   Fact of Liability

     For an item to be deductible, the fact of liability must be

“firmly established”, “fixed and certain”, and “fixed and

absolute”.   Colonial Wholesale Beverage Corp. v. Commissioner,

T.C. Memo. 1988-405 (and cases cited therein), affd. 878 F.2d 23

(1st Cir. 1989).   It is well established that liabilities may not

be accrued while they are still contingent.   Vastola v.

Commissioner, 84 T.C. 969, 977 (1985) (and cases cited therein).

However, a contingency limited to the timing of the required

payment may not prevent an item from satisfying the all-events

test.   Restore, Inc. v. Commissioner, supra (citing United States

v. Hughes Props., Inc., 476 U.S. 593, 604 (1986)).    Respondent

contends that the litigation and the related correspondence

between National and the other litigants indicate that the

liability remained in dispute into 2000 and thus remained

contingent on December 31, 1999.

     Respondent is correct to the extent that the correspondence

between F&D and National before October 18, 1999, reflected a

continuing dispute regarding whether National was liable to F&D

under the indemnity agreement, and that National was making a

settlement offer in hopes of avoiding litigation.    Contrary to

respondent’s contention, however, all of the correspondence

beginning with the October 18, 1999, letter, indicates that

National recognized an obligation to F&D under the indemnity
                                - 10 -

agreement.    In that regard, petitioners and respondent stipulated

that National acknowledged by the end of taxable year 1999 that

it had an obligation to F&D under the indemnity agreement.

Following the October 18, 1999, letter, the remaining differences

focused mainly upon the aspects of payment, such as timing, an

aspect that will not prevent the items from satisfying the all-

events test.    See United States v. Hughes Props., Inc., supra at

604.    The fact that the litigation was not resolved does not,

ipso facto, indicate that National disputed whether it had an

obligation under the indemnity agreement.    It should be noted

that the parties to this case stipulated that National recognized

its obligation to F&D under the indemnity agreement by the end of

1999.    National and F&D’s continuing disagreement concerned

aspects of the terms of the obligation.    However, the existence

of the liability was not contested and could be established with

reasonable certainty.

       In this case, all of the events had occurred to establish a

liability:     F&D and National entered into an indemnity agreement,

circumstances arose necessitating performance under the indemnity

agreement, and National was obligated to pay F&D under the

indemnity agreement.    Accordingly, the $2,500,000 claimed

reduction to income was not a “contingent” liability, as

respondent contends.    The fact of liability could be established

as of December 31, 1999.
                               - 11 -

     b.   Amount of the Liability

     The amount of the liability must be determinable with

reasonable accuracy.    Sec. 461(h)(4).   Respondent argues that at

the end of 1999, there was disagreement as to the amount National

would be required to pay.    We hold that any uncertainty that

remained as of December 31, 1999, was insufficient to preclude a

deduction for 1999.

     The regulations address uncertainty as to the amount of a

liability as follows:

     While no liability shall be taken into account before
     economic performance and all of the events that fix the
     liability have occurred, the fact that the exact amount
     of the liability cannot be determined does not prevent
     a taxpayer from taking into account that portion of the
     amount of the liability which can be computed with
     reasonable accuracy within the taxable year. For
     example, A renders services to B during the taxable
     year for which A charges $10,000. B admits a liability
     to A for $6,000 but contests the remainder. B may take
     into account only $6,000 as an expense for the taxable
     year in which the services were rendered. [Sec. 1.461-
     1(a)(2)(ii), Income Tax Regs.]

     As discussed above, National acknowledged that it had an

obligation to F&D under the indemnity agreement.    The litigation

and the related correspondence between F&D and National reflected

that there was disagreement about the total amount for which

National might be liable.    However, the November 9, 1999, letter

shows that National admitted its obligation was over $2,500,000
                                - 12 -

under the indemnity agreement.7    Even though National

acknowledged it was liable for at least $2,500,000 under the

indemnity agreement, respondent contends that the total amount of

National’s liability was uncertain.      The total amount continued

to be in dispute because of, among other things, the District’s

demands regarding completion of the project.     While it is true

that National’s total obligation with regard to the completed

construction remained uncertain at the end of 1999, that did not

alter the fact that National’s acknowledged minimum obligation to

F&D under the indemnity agreement was $2,500,000.     The $2,500,000

constitutes an uncontested amount similar to the $6,000

uncontested amount described in the regulations.     See sec. 1.461-

1(a)(2)(ii), Income Tax Regs.     The liability is thus determinable

with reasonably accuracy to the extent of the uncontested

$2,500,000 amount.

2.   Economic Performance

     The all events test will not be treated as met any earlier

than when economic performance occurs.     Sec. 461(h)(1).   The

occurrence of economic performance depends upon the circumstances

underlying a liability or the obligations a liability creates.

See sec. 461(h)(2).   In that regard, respondent argues that the

liability arose out of National’s alleged breach of the indemnity


     7
      The parties stipulated for purposes of this case that
National recognized it had an obligation to F&D of more than
$2,500,000 under the indemnity agreement as of Dec. 31, 1999.
                               - 13 -

agreement.    Petitioners argue that the liability arose because of

F&D’s performance under the performance bond and the indemnity

agreement.    We agree with petitioners.

       An analysis of National’s contractual obligations under the

various agreements is helpful in our consideration of the nature

of the $2,500,000 claimed by National.     National and the District

entered into the construction contract, which also required

National to obtain a performance bond.     National breached its

obligation to properly complete the construction contract.     It

was not that failure to perform, however, that gave rise to

National’s $2,500,000 obligation to F&D.     National’s failure to

perform its construction obligation to the District gave rise to

a separate set of contractual obligations between National and

F&D.    F&D became obligated to perform under its performance bond

with National, which, in turn, caused National to become

obligated to indemnify F&D.    As acknowledged by respondent, the

consideration in the bond and the indemnity contract was F&D’s

promise to complete the project, in exchange for National’s

promise to pay a fee and to indemnify for the costs F&D incurred

in its performance under the indemnity agreement.     National’s

inability to meet its obligations to the District was the

condition precedent to F&D’s performance.
                              - 14 -

     Respondent contends that the performance bond agreement, in

effect, was a third party beneficiary contract under which

National received no consideration.    Respondent, in making that

contention, overlooks the fact that the separate contractual

obligations between F&D and National had mutual exchanges of

consideration.   A third party beneficiary contract is one that

directly benefits a third party and that provides the third party

with a right to sue the original contracting parties for breach.

Black’s Law Dictionary 349 (8th ed. 2004).    The only potential

third party beneficiary in this case would be the District, which

might have had a right to sue F&D if F&D had failed to fulfill

its obligations under the performance bond.    Therefore, F&D

agreed to complete National’s performance for the project in

exchange for National’s agreement to reimburse F&D for all costs

incurred.

     Respondent also contends that National’s $2,500,000

obligation arose because of its breach of the indemnity

agreement.   Respondent therefore asserts that economic

performance occurs when payment is made, as described in section

1.461-4(g)(2), Income Tax Regs.   However, National only failed to

meet its contractual obligation with the District.    By December

31, 1999, National and F&D were continuing to negotiate the

timing and total amount of payments under the indemnity

agreement.   No breach of contract had been alleged or occurred.
                              - 15 -

Respondent, in support of his contention that National breached

or failed to perform its contractual obligation to F&D, relies on

F&D’s allegations of breach of contract in its June 2000

complaint concerning the performance bond and indemnity contract.

Respondent’s reasoning is unconvincing.     F&D’s allegations in its

June 2000 pleading were made after National acknowledged its

$2,500,000 indemnity obligation to F&D.     Allegations of breach of

contract after the close of 1999 would not affect the status of

National’s recognition of the liability in 1999.     Accordingly, we

reject respondent’s contention that the liability arose out of a

breach of contract.

     With respect to the accrual of a deduction arising in

connection with the providing of services, economic performance

occurs as the services are provided.     Sec. 461(h)(2)(A)(i); sec.

1.461-4(d)(2)(i), Income Tax Regs.     Services provided to a

taxpayer also include services provided to another person at a

taxpayer’s direction.   Sec. 1.461-4(d)(6)(i), Income Tax Regs.

We have already decided that the liability arose out of F&D’s

promise to perform under the performance bond.     Respondent

contends that if the performance bond and the indemnity agreement

are to be considered separate from the construction contract,

then we should view F&D’s services as having been rendered to the

District.   In that regard, the work or services performed by F&D

in completing the construction contract is a benefit to National,
                                 - 16 -

and economic performance occurs as F&D performs the services;

i.e., as F&D completes construction of the project.    The parties

stipulated that, as of December 31, 1999, F&D had incurred over

$2,500,000 in costs relating to its efforts to complete the

project.    Therefore, economic performance had occurred with

respect to $2,500,000 during 1999.

3.   Conclusion

     Because we have found that the requirements of the all-

events test were met in 1999 and that economic performance

occurred in 1999, the $2,500,000 liability had accrued and was

deductible for National’s and therefore petitioners’ 1999 tax

years.     See sec. 461(h)(1).


                                 Decisions will be entered

                            under Rule 155.
