The number of petitioner's employees eligible to receive benefits and whose holiday pay was funded pursuant to the holiday pay plan during 1986 and subsequent years was as follows:

The assets in VEBA II consisted of cash, State and municipal securities, and shares of a regulated investment company. These assets were held in custodial accounts. The amounts of investment earnings produced by the principal in the VEBA II trust were as follows:

Petitioner paid holiday pay directly to its employees who were covered by VEBA II. The amounts of holiday pay benefits for fixed holidays paid to employees covered by the holiday pay plan were as follows:

Year

1986 ...

1987 .... 1988 ..

Holiday pay plan benefits paid

$1,523,997

1,896,719
1,800,515

The investment earnings of the VEBA II trust were distributed from the trust to petitioner to reimburse petitioner for the amounts of holiday pay it paid to employees. No portion of the $20 million principal in the VEBA II trust has been distributed. After 1986, the investment earnings from VEBA II were insufficient to reimburse petitioner completely for its holiday pay obligations. During the years 1987 through 1994, the difference between petitioner's fixed holiday pay obligations covered by VEBA II and the investment earnings from VEBA II was supplied from the following sources:

On petitioner's annual statement filed with the State of Connecticut Insurance Department for 1985, petitioner treated the $20 million contribution to VEBA II as an expense and charged the contribution directly to its capital and surplus account. In 1992, petitioner sought and received approval from the State Insurance Department to report the $20 million principal in VEBA II as an asset. Thereafter, petitioner reported the VEBA II trust as an admitted asset on its annual statements. The change in petitioner's annual statement reporting resulted from its desire to change to an accounting

practice similar to that adopted in the Statement of Financial Accounting Standards No. 87.

VEBA III

Subsequent to the establishment of the holiday pay plan and the VEBA II trust, petitioner established a third VEBA trust (VEBA III) in order to fund its wellness program and health services plans. Petitioner contributed $10 million to VEBA III in 1986 but claimed no Federal income tax deduction in the year of contribution.8 In 1991 and 1992, petitioner liquidated VEBA III because of expense problems and capital and surplus management considerations. Petitioner used the funds from VEBA III to pay employee benefits other than those provided under the wellness and health services plans.9 Over $1 million, for instance, was used to fund vacation pay for petitioner's employees. By using the assets of VEBA III to pay employee benefit expenses, petitioner's expenses for the year were reduced, and petitioner was able to maintain surplus growth.

OPINION

The issue for decision is whether petitioner is entitled to a section 162(a) deduction for its $20 million contribution to the voluntary employees' beneficiary association (VEBA II) trust established to provide holiday pay to its employees.

Section 162(a) allows a deduction for all ordinary and necessary business expenses paid or incurred during the taxable year. With respect to deductions for employee benefits, section 1.162-10(a), Income Tax Regs., provides as follows:

Amounts paid or accrued within the taxable year for dismissal wages, unemployment benefits, guaranteed annual wages, vacations, or a sickness, accident, hospitalization, medical expense, recreational, welfare, or similar benefit plan, are deductible under section 162(a) if they are ordinary and necessary expenses of the trade or business. *** [Emphasis added.]

In order to qualify for deduction under section 162(a), five requirements must be satisfied. The item must: (1) Be paid or incurred during the taxable year; (2) be for carrying on a trade or business; (3) be an expense; (4) be a "necessary"

8 See infra p. 459.

9 Petitioner did not terminate these plans; they remained intact but were unfunded.

expense; and (5) be an "ordinary" expense. Commissioner v. Lincoln Sav. & Loan Association, 403 U.S. 345, 352 (1971). A capital expenditure, in contrast, is not an "ordinary" expenditure within the meaning of section 162(a) and is therefore not currently deductible. Id. at 353; see sec. 263(a). Deductions from gross income are a matter of legislative grace, and taxpayers bear the burden of demonstrating that they are entitled to the deductions they claim. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).

The principal effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer's cost recovery. A business expense is currently deductible, while a capital expenditure is normally amortized and depreciated over the life of the relevant asset, or, if no specific asset or useful life can be ascertained, is deductible upon dissolution of the enterprise. INDOPCO, Inc. v. Commissioner, supra at 83-84.

The Supreme Court's decision in INDOPCO, Inc. v. Commissioner, supra, serves as the starting point for any discussion on the distinction between ordinary and necessary business expenses and capital expenditures. The Court emphasized at the outset "that the 'decisive distinctions' between current expenses and capital expenditures ‘are those of degree and not of kind'". Id. at 86 (quoting Welch v. Helvering, 290 U.S. 111, 114 (1933)). As a result, "the cases sometimes appear difficult to harmonize." Id. The Court then rejected the argument that the creation or enhancement of a separate and distinct asset is a prerequisite to capitalization, explaining that "the creation of a separate and distinct asset well may be a sufficient, but not a necessary, condition to classification as a capital expenditure." Id. at 87. The Supreme Court went on to hold that capitalization is also required when the expenditure provides the taxpayer with significant benefits beyond the year in which the expenditure is incurred. Id. at 87-89. The Court cautioned, however, that "the mere presence of an incidental future benefit-'some future aspect'—may not warrant capitalization”. Id. at 87. Applying these principles to the case at hand, we must inquire into the duration and extent of any benefits that petitioner received as a result of its $20 million contribution to the VEBA II trust in 1985. See Black Hills Corp. v. Commissioner, 73 F.3d 799, 806 (8th Cir. 1996), affg. 102 T.C. 505

(1994); A.E. Staley Manufacturing Co. v. Commissioner, 105 T.C. 166, 194 (1995).

Petitioner has provided its employees with fixed paid holidays for the past 150 years. This holiday pay was a quid pro quo for the employees' services. Petitioner's employees were paid for a designated holiday only if they were employed by petitioner on the working days immediately preceding and following the holiday.

Through its contribution to the VEBA II trust, petitioner effectively prefunded a substantial portion of its anticipated holiday pay obligations for many years to come. Petitioner's own expert witness, Stanley B. Rossman, opined that petitioner's $20 million contribution in 1985 was sufficient to pay holiday pay benefits for 8 to 10 years. Mr. Rossman assumed that both income and principal from VEBA II would be used to fund the full amount of petitioner's annual holiday pay obligations. We believe this is a very conservative estimate considering the fact that average annual holiday pay covered by the plan for the years 1986 through 1994 was approximately $2 million. At that rate, the $20 million fund would last for 10 years even if it generated no investment income. In fact, investment earnings from VEBA II covered over 80 percent of petitioner's holiday pay obligations between 1986 and 1994.10

Petitioner, nevertheless, argues that its contribution should be deductible because it is the employees, rather than petitioner, who benefited from the creation of the VEBA and that any future benefit to petitioner was merely incidental. In support of its position, petitioner relies on two prior decisions of this Court in which we permitted employers to deduct VEBA contributions pursuant to section 162(a).

In Moser v. Commissioner, T.C. Memo. 1989–142, affd. on other grounds 914 F.2d 1040 (8th Cir. 1990), we held that a corporation was entitled to a deduction pursuant to section 162(a) for a $200,000 contribution to a VEBA created to provide members with death benefits, sickness and accident benefits, and severance pay benefits. Since the benefits provided by the VEBA were commensurate with the salaries and

10 Petitioner has avoided using any of the original principal to pay its holiday pay obligations. Since 1987, the annual investment earnings from the VEBA II trust have been insufficient to cover the total annual cost of petitioner's holiday pay obligations. To make up the difference, petitioner has either transferred funds from VEBA I or VEBA III or funded the difference itself.