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Industry Director Directive on IRC Section 172(f) Specified Liability Losses - Attachment 1

Attachment 1

Issue Name:          
Product Liability


IRC §172(b)(1)(C) requires a taxpayer with a specified liability loss to carry this loss back for 10 years rather than the usual two-year net operating loss (NOL) carryback period.  The taxpayer can make an election under IRC §172(f)(6) to irrevocably relinquish the 10-year carryback period.  The term “specified liability loss” is defined in IRC §172(f)(1).

IRC §172(f)(1)(A) provides that a specified liability loss includes an amount allowable as a deduction under IRC §§162 or 165 which is attributable to product liability or to expenses incurred in investigating, settling or opposing claims against the taxpayer on account of product liability.

IRC §172(f)(2) limits the amount of the specified liability loss to the amount of the NOL for the year.  To the extent the NOL exceeds the specified liability loss; any excess is then carried back 2 years following the regular NOL carryback rules

IRC §172(f)(4) defines a product liability as:

(A) liability of the taxpayer for damages on account of physical injury or emotional harm to individuals, or damage to or loss of the use of property, on account of any defect in any product which is manufactured, leased, or sold by the taxpayer, but only if

(B) such injury, harm, or damage arises after the taxpayer has completed or terminated operations with respect to, and has relinquished possession of, such product.

Product liability losses do not include injuries to employees while manufacturing the product, or injuries or damages sustained while delivering, installing or testing the product for the customer.  Product liability losses do not include normal costs of repairs and maintenance or warranty items or liabilities incurred as a result of services performed by the taxpayer. 

▲ Caution!

Note that while the statute expressly includes expenses incurred in investigating, settling, and opposing claims in defining product liability losses, it does not repeat these expenses in the definitions of the other five permitted categories of specified liability losses listed in IRC §172(f)(1)(B).

The additional requirements for specified liability loss treatment contained in IRC §172(f)(1)(B)(ii) do not apply to product liability expenses.  Thus, for product liability losses only, the taxpayer need not have been on the accrual method of accounting for the entire period and the liability need not arise from an act which occurs at least 3 years before the beginning of the loss year.

Some potential product liability loss issues examiners need to be aware of include the following:

  • Issue 1: Differences between product liability and other specified liability losses
  • Issue 2: Damages vs. product replacement/warranty expenses
  • Issue 3: Damages prior to completing delivery do not qualify
  • Issue 4: Proper treatment of insurance reimbursements

Issue 1: Differences between product liability and other specified liability losses

Although now included within the same Code section, the greatest similarity between product liability losses and the other permitted forms of specified liability losses are that both have a special 10-year carryback provision.  Product liability losses and their special carryback rules were enacted first and carry far fewer restrictions than other specified liability losses.  While there are Regulations for product liability losses, there are none for the other forms of specified liability losses.

Congress first enlarged the carryback period for NOLs attributable to product liability (product liability losses) in the Revenue Act of 1978. This enactment constituted part of a congressional response to a perceived business crisis arising from product liability claims, including an inability to obtain product liability insurance at reasonable prices. Congress provided a larger carryback period for product liability losses because product liabilities tend to be large and sporadic. The expanded carryback period reduces the likelihood that a large product liability loss will exceed taxable income during the carryback period. Staff of the Joint Committee on Taxation, 95th Cong., General Explanation of the Revenue Act of 1978 232 (Comm. Print 1979). Taxpayers receiving tax refunds attributable to the larger carryback period could also use those funds to pay product liability claims. 124 Cong. Rec. 34,733 (1978).

The definition of what constitutes a product liability varies among the states and has changed over time.  Regulation §1.172-13(b)(2)(iii) clarifies that the federal tax definition of product liability controls rather than state law when it comes to IRC §172(f). TAM 2003410041  involved a taxpayer’s claim of product liability treatment for defective fasteners it manufactured.  The amounts included both cash payments to customers and accounts receivable write-offs.  The taxpayer could not trace the manufacturing deficiencies to particular production lots and thus had to test and repair (rework) a substantial quantity of fasteners.  Some of the taxpayer’s customers stopped paying for items already shipped to them claiming that testing and other costs exceeded any amount they owed the taxpayer.  Some customers asserted claims for additional inventory carrying costs since they could not sell these defective fasteners.  Other customers claimed “cover” charges since they had to find a replacement supplier for the fasteners at a higher than contracted for cost.  The damages at issue did not involve actual personal injury or physical property damage.  The TAM provides considerable discussion about how product liability is defined for tax purposes and concludes that the taxpayer’s damages do not qualify for the 10-year carryback.

1  Technical Advice Memorandum (TAM) 143949-01, TAM 200341004 (Oct. 10, 2003), discusses the manner in which product liability is defined for tax purposes.  Do not cite this TAM as precedent per IRC §6110(k)(3), as the disclaimer at the end of this memorandum directs.  See, e.g., IRM

Regulation §1.172-13(b)(2)(i) largely echoes the definition of product liability provided in the statute. The regulations further provide, however, that a taxpayer's liability for damage done to other property or for harm done to persons that is attributable to a defective product may be product liability regardless of whether the claim sounds in tort or contract.  The damages must result from physical injury or emotional harm to individuals, or damage to or loss of the use of property, on account of a defect in the product manufactured, leased, or sold by the taxpayer.  The damages must occur after the taxpayer has relinquished possession of the product.

This concept is illustrated by Regulation §1.172-13(b)(3) Example (1) where a heating equipment manufacturer sells a boiler to a customer.  If the boiler explodes and injures the customer after the boiler was fully installed and turned over to the customer, payment for the customer’s physical injuries qualifies as product liability.

Product liability losses are not subject to the 3-year rule applicable to other types of specified liability losses under IRC §172(f)(1)(B)(ii)(I).

Specified liability losses for the 5 items specifically enumerated in IRC §172(f)(1)(B)(i) only include amounts “in satisfaction of” the otherwise qualifying liability.  Product liability losses, by definition under IRC §172(f)(1)(A)(ii), also include the expenses incurred to investigate, settle or oppose product liability claims against the taxpayer.  This is not an unlimited license however to include all items, no matter how remotely connected.  Regulation §1.172-13(b)(1)(ii)(B) provides “Indirect corporate expense, or overhead, is not to be allocated to product liability claims so as to become a product liability loss.”

Regulation §1.172-13(b)(2)(ii) specifically excludes liability incurred as a result of services performed by the taxpayer from the definition of product liability.  Where both a product and services are integral parts of the transaction, product liability cannot occur until after the taxpayer has relinquished possession of the product.  The service based exclusion is illustrated by Regulation §1.172-13(b)(3) Example (3) where a medical association is sued for the malpractice of one of its doctors.  This service based damage payment does not qualify as product liability.

Regulation §1.172-13(b)(2)(iv) and (v) cover the basic rule that amounts paid for insurance against product liability are not paid on account of product liability and the limited exceptions.

Audit Steps

  • Examiners should request a detailed break down of product liability amounts claimed in order to determine if the items are included within the definition of product liability expenses.  Verify that all the requirements and exclusions have been met.
  • Product liability expenses Uniform Issue List (UIL) Code 172.06-00 refers to product liability issues and UIL 172.07-00 refers to other specified liability losses

Issue 2: Damages vs. product replacement/warranty expenses

Regulation §1.172-13(b)(2)(ii) provides that the term "product liability" does not include liabilities arising under warranty theories relating to repair or replacement of the property that are essentially contract liabilities.  “For example, costs incurred by a taxpayer in repairing or replacing defective products under the terms of a warranty, express or implied, are not product liability losses.”

Agents have encountered situations where the taxpayer manufactures small appliances such as toasters.  When the product does not work, the taxpayer replaces the appliance or refunds the customer’s purchase price.  The taxpayer then includes these costs in the 10-year carryback computation.  This is not correct.  If the defective product caught fire and damaged the customer’s house, the amounts paid for the customer’s damages would qualify while the cost of replacing the defective item would not.

Taxpayers often attempt to claim the cost of product or safety equipment recalls (both voluntary and involuntary) as product liability expenses even though the products caused no harm or injury.  When the taxpayer produces and sells a product it is, at the very least, implicit that the product is in proper operating condition and will perform the job for which it is sold.  If the product is defective and the taxpayer must incur costs to recall and replace the product, these costs are nothing more than liabilities arising under a warranty theory, essentially a contract liability.  They do not qualify as product liability expenses or losses.

Regulation §1.172-13(b)(3) Example (2) illustrates this point.  If the manufacturer of heating equipment sells a boiler to a customer and the boiler explodes after it has
been installed and turned over to the customer, while the cost of damage or injury caused by the boiler qualifies as a product liability loss, the cost to replace or repair the boiler does not.

Audit Steps

  • Differentiate between costs incurred for damages or injury caused by the defective product and those for repairing or replacing the defective product.

Issue 3: Damages prior to completing delivery do not qualify

IRC §172(f)(4)(B) limits product liability to injury, harm or damage which “arises after the taxpayer has completed or terminated operations with respect to, and has relinquished possession of, such product.”

Regulation §1.172-13(b)(3) contains examples which illustrate this principle.  In Example (4), the retailer of communications equipment is in the process of installing the equipment for the customer when the unit catches on fire.  Because the retailer had not relinquished control of the equipment, amounts paid to the customer for damage to the customer’s property are not payments on account of product liability.  Had the retailer finished the installation and relinquished control to the customer, the damages would have constituted payments on account of product liability as illustrated by Example (5).  Similarly, if the equipment later catches on fire during a subsequent service visit by the retailer, the amounts paid for customer property damages qualify as product liability expenses as shown by Example (6).

Regulation §1.172-13(b)(3) Example (7) deals with a computer manufacturer who sells a computer to the customer.  The manufacturer also has employees who periodically service the computer after the initial delivery, installation, servicing and testing have been completed.  If the computer catches fire during one of these subsequent service calls, amounts paid for property damage to the customer’s office and physical injury to the customer are considered product liability payments

IRS vs. Harvard Secured Creditors Liquidation Trust, 96 A.F.T.R.2d ¶ 6409 (D.N.J. 2005), dealt with settlement payments relating to defective aircraft parts manufactured by a Harvard division.  The District Court held that Harvard’s product liability losses do not qualify as specified liability losses under IRC §172(f)(4).

The District Court looked to Black’s Law Dictionary 963 (8th ed. 2004) for the definition of “loss”:  “failure to maintain possession of a thing”.  The court stated “There is no dispute that the intended use of the lock-nuts was inventory for resale by Harvard’s customers.  It follows that the loss of such use, under the definition of loss cited above, could not have occurred.  Loss contemplates possession followed by the failure to maintain possession.  Harvard’s customers did not have possession of lock-nuts fit for resale at any point; they merely had possession of defective lock-nuts that were unfit for resale. Consequently, Harvard's customers could not have lost the use of the property for its intended purpose where they did not possess usable lock-nuts in the first place.”

The District Court also addressed the requirement that the taxpayer must have relinquished possession of the product.  “In the instant case, the defect that gave rise to Harvard's liability arose during the manufacturing of the lock-nuts, as Harvard's own brief admits. (Appellee's Br. at 5). Since the damage to the property clearly occurred before Harvard relinquished possession of the product, the damage to the lock-nuts is excepted from the statutory definition of product liability as stated in 26 U.S.C. section 172(f)(4).”

Audit Steps

  • Examiners should review any claims for damages resulting injury, harm, or damage due to defective products to ensure that the taxpayer had completed all the necessary steps to deliver, install, initially service and test the equipment and relinquish control to the customer before the defective product malfunctioned.  For large projects this may involve inspecting all the contracts and any necessary sign-offs on building or other permits.  Details can also be found in the court documents or complaints filed against the taxpayer alleging liability for damages.
  • Be sure to examine any product liability insurance policies or other coverage the taxpayer maintains to determine if the taxpayer was reimbursed for the damage expenditures.  Such insurance should be both included in income and offset against the related damage payments for purposes of IRC §172(f).

Issue 4: Proper treatment of insurance reimbursements

This is an area where we have encountered significant differences in treatment by taxpayers.  Some taxpayers have failed to report the insurance reimbursements, either on an as received basis or by accrual even though the taxpayer has a reasonable prospect of recovery.  These taxpayers have instead deducted the expense payments and treated them as eligible for a 10-year carryback.  See FSA 1992 WL 1354825 which concluded, based upon its facts, that even though a contested liability is paid, a deduction may not be accrued “because under these facts a right to reimbursement existed which was virtually certain to be paid.  Such a right to reimbursement precludes a section 162 trade or business deduction.”

2    Field Service Advisory Memorandum (FSA) 1027A, 1992 WL 1354825 (1992), discusses the applicable law and potential taxpayer positions regarding this issue.  Do not cite this FSA as precedent per IRC §6110(k)(3), as the disclaimer at the end of this memorandum directs.

Other taxpayers, while reporting the insurance reimbursements in income, have failed to offset the insurance reimbursements against the related expenditures before computing the 10-year carryback amount.  The typical taxpayer position in support of this treatment is that only IRC §165 contains the language “and not compensated for by insurance or otherwise” while these expenditures are deducted under IRC §162.

One taxpayer, in the environmental remediation area, contended that insurance settlement payments received under third-party Commercial General Liability policies were monies received due to an involuntary conversion under IRC §1033(a)(2).  TAM 200322017 concluded that insurance settlement payments received by the taxpayer in this scenario were monies received for indemnification with respect to tort liability and not monies received due to an involuntary conversion.

3   TAM 200322017 (Feb. 13, 2003), discusses the applicable law surrounding the treatment of insurance settlement payments and the nonapplicability of IRC §1033.  Do not cite this TAM as precedent per IRC §6110(k)(3), as the disclaimer at the end of this memorandum directs.

Page Last Reviewed or Updated: 06-Nov-2014