n-05-20.pdf

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Part III - Administrative, Procedural, and Miscellaneous

Specified Liability Losses

Notice 2005-20

PURPOSE

This notice addresses several questions of statutory interpretation arising under
§ 172(f)(1)(B) of the Internal Revenue Code prior to its amendment by § 3004(a) of the
Tax and Trade Relief Extension Act of 1998 (former § 172(f)(1)(B)). The amendment to
former § 172(f)(1)(B) is effective for net operating losses (NOLs) arising in taxable years
ending after October 21, 1998.
BACKGROUND
The Statute
Section 172(b)(1)(C) provides that the portion of any NOL that qualifies as a
specified liability loss may be carried back to each of the 10 taxable years preceding the
taxable year of the loss. For NOLs arising in taxable years ending prior to October 22,
1998, former § 172(f)(1)(B) treats as a specified liability loss the portion of the NOL
generated by:
(B) [a]ny amount [other than product liability expenses and certain
expenses related thereto] allowable as a deduction under [chapter 1 of the
Internal Revenue Code] with respect to a liability which arises under a
Federal or State law or out of any tort of the taxpayer if-

(i) in the case of a liability arising out of a Federal or State law, the
act (or failure to act) giving rise to such liability occurs at least 3 years
before the beginning of the taxable year, or

(ii) in the case of a liability arising out of a tort, such liability arises

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out of a series of actions (or failures to act) over an extended period of
time a substantial portion of which occurs at least 3 years before the
beginning of the taxable year.

For this purpose, a liability is not taken into account unless the taxpayer used an accrual
method of accounting throughout the period or periods during which the acts or failures
to act giving rise to the liability occurred.
The Sealy Decisions

In Sealy Corp. v. Commissioner, 107 T. C. 177 (1996), aff’d, 171 F.3d 655 (9
th

Cir. 1999), the Tax Court held that the portion of NOLs generated by deductions for the
following liabilities did not result in former § 172(f)(1)(B) specified liability losses:
(1) professional fees incurred to comply with current reporting, filing, and
disclosure requirements imposed by the Securities and Exchange Act of 1934;
(2) professional fees incurred to comply with current ERISA reporting
requirements; and
(3) professional fees incurred in connection with an income tax audit by the
Service for a prior taxable year.
The Tax Court gave three reasons for its conclusion that these liabilities did not
arise under a federal or state law within the meaning of former § 172(f)(1)(B). First, the
federal laws cited by the taxpayers did not establish their liability to pay the amounts at
issue. Instead, the taxpayers’ liabilities did not arise until the services were contracted
for and received and the taxpayers’ choice of the means of compliance, rather than the
cited provisions, determined the nature and amount of their costs. Sealy at 184.
Second, Congress intended former §172(f)(1)(B) to apply only to liabilities for which a
deduction is deferred because of the economic performance requirement of § 461(h).

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The economic performance requirement did not delay the taxpayers' accrual of the
deductions at issue. Sealy at 185-86. Third, invoking the statutory construction rule of
ejusdem generis, the court concluded that Congress intended the 10-year carryback to
apply to a relatively narrow class of liabilities similar to other liabilities referred to in
former § 172(f). Sealy at 186.
In affirming the Tax Court’s judgment, the Ninth Circuit stated that the acts giving
rise to the liabilities at issue in Sealy were contractual acts by which Sealy engaged
lawyers or accountants and did not occur at least 3 years before the beginning of the
taxable year of the related deductions as required by former § 172(f)(1)(B)(i).
The Host Marriot and Intermet Decisions
In Host Marriott Corp. v. United States, 113 F. Supp. 2d 790 (D. Md. 2000), aff’d,
267 F.3d 363 (4
th
Cir. 2001), the district court concluded that interest liabilities on
federal tax deficiencies arise under federal law within the meaning of former
§172(f)(1)(B). The court pointed out that § 6601(a) imposes interest on due but unpaid
federal taxes. The court noted that, in contrast to the situation in Sealy, the interest
liabilities were set by federal law, not by the taxpayer’s choice.
In Intermet Corp. v. Commissioner, 117 T.C. 133 (2001), the Tax Court cited
Host Marriot and concluded that liabilities for state tax deficiencies, interest on state tax
deficiencies, and interest on a federal income tax deficiency arise under federal or state
law within the meaning of former § 172(f)(1)(B). In distinguishing Sealy, the Tax Court
only referred to the first reason (i.e., federal law did not establish the liability to pay the
amounts at issue) that it gave in Sealy for concluding that the professional fee liabilities
at issue in that case did not arise under federal or state law.

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In addition, in both Host Marriot and Intermet, the courts concluded that the filing
of an erroneous tax return, resulting in the initial failure to timely pay the entire amount
of tax due, constitutes the act giving rise to the entire compound interest liability on
unpaid tax.
The Major Paint Decision
In Major Paint Co. v. United States, 334 F.3d 1042 (Fed. Cir. 2003), aff’g
Standard Brands Liquidating Creditor Trust v. United States, 53 Fed. Cl. 25 (2002), the
Federal Circuit held that liabilities for capitalized legal, accounting, and other
professional fees and expenses incurred pursuant to a reorganization bankruptcy under
Chapter 11 of Title 11 of the United States Code did not arise under federal law for
purposes of former § 172(f)(1)(B). The fees included those incurred by the taxpayer on
its own behalf as well as fees incurred on behalf of the unsecured creditors’ committee
but required to be paid from the bankruptcy estate. The taxpayer capitalized a portion
of the fees incurred as a result of the reorganization bankruptcy and later deducted the
capitalized fees upon a subsequent voluntary liquidating bankruptcy.
The Bankruptcy Code requires the appointment of an unsecured creditors’
committee and allows the committee, with court approval, to employ various
professionals to perform services for the committee. The Bankruptcy Code also
requires the bankruptcy court to approve the employment of the professionals, the
terms of their employment, and the amounts paid to them. In Major Paint, a local court
rule required the bankrupt taxpayer to employ counsel.
The Federal Circuit analyzed the opinions in Sealy, Host Marriot, and Intermet,
from which it concluded two principles could be derived. First, “‘arising out of a federal

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law’ means more than just that the liability is incurred with respect to an obligation under
a federal law.” 334 F.3d at 1046. Second, “the nature and amount of the liability must
be traceable to a specific law and cannot be the result of choices made by the taxpayer
or others.” Id. As in Sealy, the statutory provisions did not establish a liability to pay the
amounts at issue. Rather, the decisions of the taxpayer and the creditors’ committee,
subject to final approval by the bankruptcy judge, as to the means of compliance
determined the nature and amount of the costs. The court concluded that the
connection between the Bankruptcy Code and the liabilities for the fees was “too
attenuated to meet the level of ‘arise under’ necessary to qualify as a specified liability
loss.” Id. at 1047.
QUESTIONS AND ANSWERS
The “Arises Under a Federal or State Law” Requirement
Q-1. What tests must a liability satisfy to arise under federal or state law within the
meaning of former § 172(f)(1)(B)?
A-1. To arise under federal or state law the liability must be directly imposed by federal
or state law and must not be the result of decisions made by the taxpayer or others.
See Sealy and Major Paint.
Q-2. May a tort liability satisfy the requirements of former § 172(f)(1)(B)(i)?
A-2. Yes. A tort liability may be directly imposed under either federal or state law. If
the act or failure to act giving rise to the tort liability occurs at least 3 years before the
beginning of the taxable year of the liability’s deduction, the requirements of former
§ 172(f)(1)(B)(i) are satisfied.
Multiple Act Torts

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Q-3. What is a tort liability that arises out of a series of actions (or failures to act) over
an extended period of time?
A-3. A tort liability that arises out of a series of actions (or failures to act) over an
extended period of time within the meaning of former § 172(f)(1)(B)(ii) is a liability that
arises only from multiple acts or failures to act over an extended period of time. An
example is a tort liability for causing someone to develop a disease because of
repeated exposures to chemicals or other toxic substances. This liability would be a tort
liability within the meaning of former § 172(f)(1)(B)(ii) if a substantial portion of the
exposures occur at least 3 years before the beginning of the taxable year of the
liability’s deduction.
On the other hand, what may appear to be a tort liability involving multiple acts,
such as a tort liability arising from a continuing trespass, is actually a number of
separate liabilities, each arising from separate acts or failures to act resulting in
separate causes of action. The Internal Revenue Service will not treat this type of
liability as a multiple act or failure to act liability that satisfies the requirements of former
§ 172(f)(1)(B)(ii). Instead, to generate a specified liability loss, the separate liabilities
must independently satisfy the 3-year act or failure to act requirement of former §
172(f)(1)(B)(i).
The “Act or Failure to Act” Requirement
Q-4. Which act in the chain of causation leading to the creation of a liability constitutes
“the act or failure to act” giving rise to that liability within the meaning of former
§ 172(f)(1)(B)(i)?
A-4. The act or failure to act resulting in the establishment of a legal liability constitutes

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the act or failure to act within the meaning of former § 172(f)(1)(B)(i). For example, in
the case of a trespass, the act of trespassing constitutes the relevant act for purposes of
former § 172(f)(1)(B)(i), not the judgment of a court.
In the case of interest on unpaid federal or state taxes, the Service continues to
believe that a taxpayer’s use of the government’s money over discrete periods, such as
days, months or portions of a month, is an essential element that creates the liability.
Therefore, the Service believes that the courts in Host Marriott and Intermet incorrectly
concluded that the initial failure to pay the taxes when due constituted the act or failure
to act giving rise to any interest that economically accrued during the taxable year such
interest was deductible and the 3-year period prior to the beginning of that taxable year.
Consequently, the Service will continue to assert that interest that economically accrues
on a liability for unpaid taxes in the taxable year such interest is deductible and the 3-
year period prior to the beginning of that taxable year does not satisfy the 3-year act or
failure to act requirement of former § 172(f)(1)(B)(i).
The “With Respect To” Requirement
Q-5. For purposes of former § 172(f)(1)(B), does a deduction allowable “with respect to”
a liability include other items, such as legal and professional fees to contest the liability
or court costs incurred to litigate the liability?
A-5. A deduction allowable with respect to a liability includes only a deduction for the
liability itself. Therefore, legal fees, court costs, and similar items do not generate a
former § 172(f)(1)(B) specified liability loss even if the liabilities are incurred in
determining the amount of a liability that does satisfy the requirements of former
§ 172(f)(1)(B).

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In Sealy, the Tax Court and Ninth Circuit held that deductions for accounting and
legal fees incurred in connection with a federal income tax audit did not generate a
specified liability loss under former § 172(f)(1)(B). Federal law directly imposed only the
federal income tax liability and did not impose the taxpayer’s liability for the accounting
and legal fees. The taxpayer’s liabilities for the accounting and legal fees arose as a
result of decisions made by the taxpayer, and such liabilities were incurred when the
services were contracted for and performed. Implicit in the Tax Court’s holding is the
conclusion that the deduction for the legal and professional fees was not, within the
meaning of § 172(f)(1)(B), allowable “with respect to” the federal tax liability that was the
subject of the audit.
Depreciation Deductions
Q-6. For purposes of § 172(f)(1)(B), are depreciation deductions allowable with respect
to the liability giving rise to the depreciable basis of a depreciable asset?
A-6. Depreciation deductions are not allowable with respect to the liability giving rise to
the depreciable basis of a depreciable asset. Depreciation deductions may be
allowable with respect to liabilities satisfied through the use of the depreciable asset.
Liabilities arising under federal or state law may be treated as part of the cost
basis of property if the liabilities are properly chargeable to a capital account. For
example, § 164(a) requires sales taxes imposed on the purchase of equipment used in
a taxpayer’s trade or business to be capitalized into the cost basis of the equipment. If
an NOL is incurred for a taxable year and the sales tax liability was incurred at least 3
years before the beginning of that taxable year, some taxpayers have asserted that any
portion of the NOL generated by depreciation deductions for the portion of the

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property’s depreciable basis attributable to the capitalized sales tax constitutes a former
§ 172(f)(1)(B) specified liability loss irrespective of how the property is used. Likewise,
taxpayers may be required to place certain equipment into service to comply with
requirements of federal or state law, for example, clean water standards. Some of
these taxpayers have asserted that if the equipment was acquired by the taxpayer at
least 3 years prior to the beginning of the taxable year, the portion of any NOL
generated for the taxable year by depreciation deductions attributable to the equipment
qualifies as a former § 172(f)(1)(B) specified liability loss. The Service disagrees with
both of these assertions.
Section 167(a) allows a depreciation deduction only for property that is either
used in a trade or business or held for the production of income. Whether a
depreciation deduction is allowable “with respect to” a liability depends upon the
property’s actual use. For example, if a taxpayer uses equipment to satisfy an
environmental cleanup liability imposed by federal law, the portion of the equipment’s
depreciation allocable to satisfying the environmental cleanup liability is allowable with
respect to the environmental cleanup liability. If the environmental cleanup liability
arose as a result of a chemical spill that occurred at least 3 years before the beginning
of the taxable year and the environmental cleanup liability is otherwise deductible, the
depreciation deductions may generate a specified liability loss. However, if a taxpayer
uses equipment to satisfy environmental cleanup liabilities that arise during the same
taxable year the depreciation deductions are allowable, for example, by preventing the
discharge of pollutants resulting from manufacturing activities during the current taxable
year, the act giving rise to the taxpayer’s environmental cleanup liability will not satisfy

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the 3-year act or failure to act requirement of former § 172(f)(1)(B)(i), irrespective of
when the taxpayer placed the cleanup equipment in service.
DRAFTING INFORMATION
The principal author of this notice is Forest Boone of the Office of Associate
Chief Counsel (Income Tax and Accounting). For further information regarding this
notice contact Mr. Boone at 202-622-4960 (not a toll-free call).