Could a corporation exclude accrued vacation reserves from taxable-capital surplus as debt when vacation would be paid at each employee's future pay rate?

Plain-English summary

The accrued vacation reserve was a contingent obligation included in surplus, not deductible debt.

Employees earned vacation time, could carry unused time up to a limit, and received payment for unused accrued vacation when they voluntarily left. But the amount paid depended on each employee's salary when vacation was taken.

That future-pay-rate feature made the reserve an estimate. It did not meet Section 171.109(a)(3)'s definition of debt as a legally enforceable obligation measured in a certain amount and payable within an ascertainable period or on demand. The Comptroller therefore upheld the auditor's addition of the reserve to taxable-capital surplus.

The taxpayer also sought penalty waiver. The decision denied it because similar errors appeared in prior related audits, the current error rate had increased, the taxpayer had an internal tax department, and treatment of contingent reserves was considered settled.

What this means for you

Employers with accrued vacation accounts

A book reserve was not excluded as debt when the eventual payment amount still depended on future salary.

Tax professionals handling historical audits

Test an employee-benefit liability against the statutory certainty requirements rather than assuming an accounting accrual equals franchise-tax debt.

Common questions

Q: Why was the reserve contingent?
A: Vacation was paid at the employee's salary when taken, so the year-end amount was not certain.

Q: Was the reserve excluded from surplus?
A: No.

Q: Was penalty waived?
A: No.

Q: What was the final audit result?
A: The liability was upheld in full.

Citations and references

• Texas Tax Code Secs. 171.101(a), 171.109(a)(1)-(3), 171.109(j), and 111.061(a)
• 34 Tex. Admin. Code Secs. 3.551(e)(7) and 3.5
• Hearing No. 36,384

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9710309H

Original ruling text

HEARING NO. 36,384

IN RE: **

TAXPAYER NO: **
AUDIT PERIOD: 1991 through 1994

FRANCHISE TAX/RDT

BEFORE THE COMPTROLLER
OF PUBLIC ACCOUNTS
OF THE STATE OF TEXAS

ROY G. SCUDDAY
Administrative Law Judge

DEAN L. KROHN
Representing Tax Division

Representing Petitioner

COMPTROLLER'S DECISION

PRELIMINARY DISCUSSION:

At Petitioner's request, the Comptroller's Decision in this case is based on a
review and consideration of the written submissions of the parties.

Unless otherwise indicated, Section references are to Title 2 of the Texas Tax
Code, and Rule references are to sections of Title 34, Texas Administrative
Code. Notice has been taken of all Comptroller's records pertinent to
Petitioner or the issues raised in this case.

PETITIONER'S CONTENTIONS:

1.Petitioner's accrued vacation reserve accounts were properly excluded from
surplus because they qualify as debt under Sec. 171.109(a)(3).

2.Penalty should be waived.

FINDINGS OF FACT:

1.**. (Petitioner) is a Delaware corporation that sells, services,
and manufactures energy-related products.

2.The Comptroller audited Petitioner for franchise tax compliance for the 1991
through 1994 report periods. On April 18, 1996, as a result of the audit, the
Comptroller issued Petitioner a Texas Notice of Tax Due for $**,
which amount included tax, penalty, and interest through the date of the
Notice.

3.The auditor adjusted Petitioner's surplus calculations by adding back
Petitioner's accrued vacation accounts, which Petitioner had excluded from its
surplus calculations. The auditor also made adjustments to Texas and
everywhere receipts to report partnership receipts.

4.Petitioner's employees earn paid vacation time as part of their compensation,
beginning with their commencement of employment. Vacation time is calculated
and paid at the employee's base pay rate at the time the vacation is taken. An
employee begins accruing vacation at the next level of benefit on the
anniversary date on which transition to the next benefit level occurs.

5.Employees can carry forward unused but accrued vacation to a maximum of twice
the annual vacation amount. Vacation cannot be accrued and saved by the
employees beyond that maximum. Employees are paid for unused but accrued
vacation if they voluntarily leave the company.

6.Petitioner was previously audited for the 1987 through 1990 report periods.
In that audit, adjustments were made to include receipt items and exclude
non-receipt items. The error percentage was .8%.

7.Petitioner had no late returns during the current audit period. Petitioner
has an internal tax department. The error percentage for this audit was 8%.
Adjustments were made in audits of companies related to Petitioner, similar to
those made in Petitioner's audit.

DISCUSSION AND CONCLUSIONS OF LAW:

Petitioner's first contention should be denied.

Petitioner contends that its accrued vacation accounts qualify as "debts" that
are excluded from the computation of surplus.

The statutes and rules applicable to Claimant's contentions are as follow:

Sec. 171.101. Determination of Net Taxable Capital

(a) Except as provided by Subsections (b) and (c), the net taxable capital of
a corporation is computed by:

(1) adding the corporation's stated capital, as defined by Article 1.02, Texas
Business Corporation Act, and the corporation's surplus, to determine the
corporation's taxable capital;
(2) apportioning the corporation's taxable capital to this state as provided
by Section 171.106(a) or (c), as applicable to determine the corporation's
apportioned taxable capital; and
(3) subtracting from the amount computed under Subdivision (2) any other
allowable deductions to determine the corporation's net taxable capital.

..........

Sec. 171.109. Surplus

(a) In this chapter:

(1) "Surplus" means the net assets of a corporation minus its stated capital.
For a limited liability company, "surplus" means the net assets of the company
minus its members' contributions. Surplus includes unrealized, estimated, or
contingent losses or obligations or any writedown of assets other than those
listed in Subsection (i) of this section net of appropriate income tax
provisions. The definition under this subdivision does not apply to earned
surplus.
(2) "Net assets" means the total assets of a corporation minus its total
debts.
(3) "Debt" means any legally enforceable obligation measured in a certain
amount of money which must be performed or paid within an ascertainable period
of time or on demand.

..........

(j) A corporation may not exclude from surplus:

(1) liabilities for compensation and other benefits provided to employees,
other than wages, that are not debt as of the end of the accounting period on
which the taxable capital component is based, including retirement, medical,
insurance, postretirement, and other similar benefits; and
(2) deferred investment tax credits.
(Subsection (j) effective January 1, 1994) [FOOTNOTE: Although subsection (j)
of Section 171.109 was added to the franchise tax statutes in 1991, the
addition of subsection (j) was intended as a clarification of the intent of
Section 171.109 adopted effective August 31, 1987. See Section 8.081 of Acts
1991, 72nd Leg., 1st Called Session, Chapter 5.]

Rule 3.551(e)(7), effective November 10, 1992, provides that "(l)iabilities for
employee compensation and benefits (e.g., pensions, bonuses, vacations,
retirement, medical, insurance, post retirement, and other similar benefits)
are included in surplus to the extent they are not debt as of the accounting
year end upon which the return is based."

The facts in this case are similar to those set forth in Comptroller's Decision
No. 33,321 (1996). That decision, in upholding the assessment, stated as
follows:

Furthermore, the Tax Division argues that since an employee's vacation pay is
accrued based upon current salaries which"... may or may not be the same when
the employees take their vacation the following year," the "... exact amount of
Petitioner's liability for vacation pay cannot be known in advance at December
31, because the exact amount depends upon what the employees' salaries are when
they receive the vacation pay."

..........

(Petitioner responds that) the minimum liability of Petitioner is reflected by
the accrual except in those situations in which employees' salaries declined,
and Petitioner will agree to an adjustment of the accrual to take into account
those instances."

As generous as that agreement to adjust the account sounds, I believe it misses
the point. Section 171.109(a)(1) clearly calls for the inclusion in surplus of
unrealized, estimated, or contingent losses or obligations. Therefore, unless
Petitioner's accrued vacation pay account comes within the strict definition of
"debt" under the Section 171.109(a)(3), it is a contingent account includible
in surplus. Petitioner's recognition that the amount accrued must be adjusted
for contingencies indicates that the amount is not certain and thus supports a
finding that the vacation pay account should not be excludable from surplus as
"debt." Furthermore, the issue of inclusion of vacation pay accounts in
surplus was recently considered and rejected by the Comptroller in
Comptroller's Decision No. 30,509 cited by the Tax Division on facts similar to
the facts in this case. (See also, Comptroller's Decision Nos. 32,154, 31,634,
30,929, 30,886, and 29,698, each decided in 1994).

Both the Tax Division and Petitioner make similar arguments to those discussed
above. However, because the amount of the vacation pay will be based on the
salary at the time it is taken, the accrued vacation account is necessarily an
estimate. Based on the holding of the cited cases, Petitioner's contention
should be denied.

In its second contention, Claimant requests that penalty be waived.

Section 111.061(a) automatically imposes a penalty on taxes not paid when they
are due, five percent on taxes not paid when originally due, and an additional
five percent on taxes more than thirty days overdue. Comptroller Rule 3.5 sets
out certain factors to be considered in determining whether a taxpayer
exercised reasonable diligence to support a waiver of penalty. Those factors
include:

(1) the taxpayer's audit history;
(2) the tax issues involved;
(3) a change in comptroller policy during the audit period;
(4) size and sophistication of the taxpayer;
(5) whether tax was collected but not remitted;
(6) whether returns were timely filed;
(7) completeness of records;
(8) delinquencies in other taxes; and
(9) reliance on advice provided by the comptroller's office which caused
imposition of penalty and interest.

Claimant argues in favor of penalty waiver based on the timely filing of its
franchise tax returns in good faith. The Tax Division responds that
Petitioner's audit showed similar errors to its prior audit, that there was an
increase in the error percentage, and that the issue of the treatment of
contingent reserves has been long-settled. Clearly from the discussion above,
it is obvious that the inclusion of accrued vacation reserves in surplus has
been settled for many years. I conclude that penalty should not be waived.

RECOMMENDATION:

The audit liability should be upheld in its entirety.

Signed 20th this day of October, 1997.

ROY G. SCUDDAY
Administrative Law Judge

Hearing No. 36,384

ORDER OF THE COMPTROLLER

The above decision of the Administrative Law Judge, resulting in Taxpayer's
liability as set out in Attachment "A" which is incorporated by reference, is
approved and adopted in all respects. This decision becomes final twenty (20)
days from the date of this Order, and the total sum of the tax, penalty and
interest amounts is due and payable within twenty (20) days thereafter. If
such sum is not paid within such time, an additional penalty of ten percent of
the taxes due will accrue, and interest will continue to accrue.

If a rehearing is desired, a Motion for Rehearing must be filed with the clerk
of the Administrative Law Judges twenty (20) days from the date of this Order,
and must state the grounds upon which the motion is based.

RENDERED and ISSUED this 20th day of October, 1997.

JOHN SHARP
Comptroller of Public Accounts
of the State of Texas