Esco Corporation v. United StatesEsco Corporation v. United States
PACTS
ESCO Corporation is subject to the Oregon Workers’ Compensation Act, Or.Rev. Stat. §§ 651.001-.990, which requires that employers ensure the payment of workers’ compensation claims, either through an independent insurance company or through self-insurance. On July 1, 1970, ESCO began self-insuring its workers’ compensation claims for amounts up to $50,000, with excess coverage provided by a commercial insurance company. Among other things, the Act required that ESCO establish and maintain a claims reserve to reflect the estimated future cost of benefits payable to injured employees. ESCO retained Employee Benefits Insurance Company, an independent claims management firm, to maintain this reserve.
When an ESCO employee is injured, a report is forwarded to Employee Benefits. If Employee Benefits does not contest the claim, it establishes a claims reserve account for the estimated liability for medical costs and compensation. These reserves are only on ESCO’s books; no funds are actually set aside. The reserve represents the overall cost of all benefits that may be paid to an injured employee and is estimated on the basis of Employee Benefits’ own reserving procedures and in compliance with the Oregon Workers' Compensation Department guidelines. It is undisputed that Employee Benefits’ estimates of ESCO’s workers’ compensation liability were more accurate than the industry average in Oregon.
Upon audit of ESCO’s 1974 and 1975 tax returns, the Commissioner of Internal Revenue disallowed the amount of workers’ compensation expense deductions that represented the estimated cost of future claims expenses. Two reasons were given. First, the amount of future liability for workers’ injuries could not be determined with reasonable accuracy and could not, therefore, be deducted until paid. See Treas.Reg. § 1.461-1(a)(2) (“all-events” test for deductibility of accrued expenses). Second, ESCO had changed impermissibly its method of accounting for these costs in 1974 from a cash basis to an accrual basis without the Commissioner’s permission. See I.R.C. § 446(e).
ESCO paid the deficiencies and then sought a refund as well as an additional deduction for the unpaid workers’ compensation liability incurred in 1973. When the Commissioner failed to act within the statutorily-prescribed period, ESCO brought suit under I.R.C. §§ 6532(a), 7422(a). ESCO asserted that its deductions for unpaid workers’ compensation expenses were determined with reasonable accuracy and thus allowable. It also claimed that it had not changed its method of accounting for this item in 1974, but rather simply employed a more accurate method of determining its accruals. Alternatively, ESCO claimed that it was entitled to a refund on its 1975 taxes for all benefits paid on claims arising in previous years.
In a trial to the court, the district court,
*1468 DISCUSSION
I. Reasonable Accuracy Issue
Under the “all-events” test of Treas.Reg. § 1.461-1(a)(2), an incurred but unpaid expense may be deducted by an accrual basis taxpayer if the liability for the expense is fixed and the amount of the expense can be determined with reasonable accuracy. As the district court correctly noted,
Kaiser Steel
controls the question of how the reasonable accuracy requirement applies to deductions for estimates of future expenses for incurred workers’ compensation claims. In
Kaiser Steel,
we held that estimates based upon industry-wide standards that were more accurate than those of the industry as a whole were reasonably accurate.
Kaiser Steel
established that the pertinent inquiry is whether the estimate of expenses was made with reasonable accuracy on the basis of facts and procedures available to the taxpayer at the end of the tax year in question.
Kaiser Steel also held that workers’ compensation estimates could be tested for accuracy on the basis of aggregate estimates rather than by each individual claim. Id. at 1309-10. In support of this, we noted that Kaiser Steel’s reserve for liability had proven to be accurate to within 7% of actual payments. Moreover, this percentage represented an underreserving. Id.
In the present case, the district court considered the initial reserve-to-actual payments comparison, which yielded a 7% inaccuracy in
Kaiser Steel,
to be dispositive of the reasonable accuracy issue. It noted that under the same test, ESCO’s witness found that ESCO had underreserved for its liabilities by 5.1%, 9.9%, and 18.5% for 1973 through 1975, respectively. The district court then averaged these figures together and held that the resulting 10.17% inaccuracy was “not sufficiently accurate for tax accounting purposes.”
ESCO Corp. v. United States,
Averaging
oí
results for all three years was inappropriate. Because federal taxation is keyed to a system of annual accounting, questions relating to income and taxation should ordinarily be analyzed on the basis of individual years and not in the aggregate.
See Wilkinson-Beane, Inc. v. Commissioner,
The district court also misunderstood our holding in
Kaiser Steel
because of language in that decision.
After
finding that the overall estimate was accurate to within 7% and represented a conservative underestimate, we held that workers’ compensation reserves could be tested for accuracy in the aggregate.
In
Kaiser Steel,
the commercial and scientific reasonableness, as well as the industry acceptance, of the taxpayer’s reserving methodology were important considerations in determining reasonable accuracy. Various hindsight evaluations of the taxpayer’s reserves were also relied upon, but they were not dispositive. The -limited significance attached to hindsight evaluation is borne out by
Wien Consolidated Airlines, Inc. v. Commissioner,
In this case, the uncontroverted testimony of the expert witnesses establishes that ESCO’s estimates were based on reasonable, commercially accepted standards and that they were more accurate than the industry norm in Oregon. Moreover, considering all of the hindsight evaluations relied upon in Kaiser Steel, the ESCO estimates are at least as accurate as the estimate we allowed there. The year-end loss development factor in Kaiser Steel indicated that the taxpayer would eventually pay out 117% of the liability reported on its tax return. The ESCO loss development factors indicate that ESCO will pay out 105%, 108%, and 110% of its reported liability for 1973 through 1975, respectively. Although ESCO’s estimate for 1975 was less accurate than the estimate in Kaiser Steel, the loss development factor indicates that ESCO’s methodology was more accurate.
The government notes that legislation overruling the
Kaiser Steel
accrual allowance of workers’ compensation claims has been passed.
See
Deficit Reduction Act of 1984, Pub.L. No. 98-369, § 91(a), 98 Stat. 494, 598-99 (1984). However, this change was not motivated, as the government contends, by concerns that estimates of liability are inherently inaccurate. Rather, Congress was concerned that accrued deductions for workers’ compensation claims understated the time value of money.
Id.
This consideration argues for acceptance of conservative underestimates of liability such as the ones in this case.
Kaiser Steel
recognized this,
see
Although the government disputes the methodology used to assess ESCO’s reserving performance, we conclude that the statistical testing was both proper and not significantly different from that employed in Kaiser Steel. Further, there is undisputed evidence that ESCO’s estimates were reasonable, generally-accepted, and better than the industry norms. We reverse the district court’s holding on this issue.
II. Change of Accounting Method Issue
We understand but disagree with the district court’s holding that ESCO had changed its method of accounting in 1974 by deducting future workers’ compensation expenses for the first time. Under I.R.C. § 446, any change in an overall accounting plan or in the accounting treatment of a material item requires the approval of the Commissioner. The record reflects the absence of the Commissioner’s permission.
ESCO contends that Joint Stipulation of Fact No. 26 establishes that its workers’ compensation claims expenses were accounted for on an accrual basis. This is not disputed; the district court acknowledged the import of this evidence.
ESCO,
ESCO makes a preliminary argument that the audit letters relied upon by the district court were not admissible under Fed.R.Evid. 408, because they were written as part of an attempt to negotiate a settlement. The government responds that the audit involved no settlement negotiations, so that Rule 408 is inapplicable. It was not error to admit the letters. ESCO did not object to the admission of its change of accounting method request and objected to *1470 the admission of the audit letters containing similar admissions only on the grounds that the letters were inaccurate and did not fall within the statement against interest exception to the hearsay rule. In so doing, ESCO waived its rights to object to admission of the letters under Rule 408. It failed to make timely and specific objections on that ground. Fed.R.Evid. 103(a)(1).
In spite of this, we agree with ESCO’s contention that the letters establish only that, prior to 1974, it was deducting that portion of accrued expenses represented by its actual cash expenditures. ESCO claims to have followed this procedure because the forecasting methodology it employed prior to 1974 was incapable of estimating its accrued claims expenses with the reasonable accuracy required by the regulations. The use of a more sophisticated forecasting methodology in 1974, ESCO further asserts, allowed it to estimate accurately, and therefore deduct, its entire workers’ compensation claims expenses. ESCO argues that its actions constitute an acceptable accrual accounting practice sanctioned by the regulations.
Once a liability is fixed, the regulations allow a taxpayer presently to deduct only that portion of its accrued expenses that can be estimated with reasonable accuracy and deduct the rest in later years. Treas. Reg. § 1.461-l(a)(2). The ESCO letters merely indicate that ESCO was deducting its workers’ compensation claims expenses in accordance with this procedure.
If ESCO deducted only a portion of its accrued expenses prior to 1974 because of insufficient statistical data and forecasting methodologies, the use of more sophisticated techniques in 1974 cannot be considered a change in accounting method. The new techniques more accurately predicted ESCO’s expenses and allowed it to avoid the underaccruals it had been experiencing. The increased deductions in 1974 are the result of “a change in treatment resulting from a change in underlying facts.” Id. § 1.446-1(e)(2)(ii)(b). It is not a change in accounting method. Id.
The letters are unambiguous and application of the regulations to them is, therefore, a question of law subject to
de novo
review.
See United States v. One Twin Engine Beech Airplane,
Reversed and remanded for computation of the refund due to ESCO.