In The Charles Schwab Corporation and Subsidiaries v. Commissioner, 122 T.C. No. 10, 2004 U.S. Tax Ct. LEXIS 10 (Mar. 9, 2004) ("Schwab II"), the Tax Court held the taxpayer was not entitled to accelerate into 1990-1992 California franchise tax deductions originally claimed for 1991-1993 for federal tax reporting purposes. The case discusses the interplay of Internal Revenue Code ("IRC") section 461(d) and 1972 California Legislation regarding the accrual date for California franchise taxes, and is a follow-up to an earlier Tax Court decision in Charles Schwab Corp. & Includible Subs. v. Commissioner, 107 T.C. 282 (1996) (Schwab I).
In Schwab I, the taxpayer had argued that a California franchise tax deduction it originally deducted on its 1989 calendar year federal return was deductible for its short year ended December 31, 1988. (The short year return was the result of the taxpayer changing its tax year for federal income tax purposes, from a March 31 fiscal year to a December 31 calendar year during 1988, so that its calendar year return ending December 31, 1988 was a short year consisting of nine months.) The Tax Court agreed. However, the decision in Schwab I left the taxpayer unable to take a deduction for California franchise tax on its 1989 calendar year federal return.
In Schwab II, the taxpayer then argued it was entitled to deduct California franchise tax liabilities for the same taxable period for which the franchise tax was calculated, i.e., the year prior to the year for which the taxpayer originally deducted the California franchise tax on its federal tax returns. In other words, the taxpayer argued franchise tax deductions originally claimed on its 1990 calendar year federal return now should be deductible on its 1989 calendar year federal return.
As explained by the Tax Court, the issue in the case arose in connection with the parties’ disagreement concerning the application and interpretation of IRC section 461(d), and section 1.461-1(d)(1) of the Income Tax Regulations. IRC section 461(d) was enacted to proscribe the acceleration of state and local tax deductions due to state or local legislation enacted after 1960. IRC section 164(a) generally provides for the deduction of qualified state and local taxes in the year paid or accrued, and the California franchise tax is a type of tax that would normally be deductible under IRC section 164(a). However, the application of IRC section 164(a) was modified during 1960 by the enactment of IRC section 461(d), which proscribes the accrual of state tax attributable to post-1960 state legislation that would accelerate the accrual of such tax.
The Tax Court explained the operation of IRC section 461(d) is illustrated by section 1.461-1(d)(3), Example (1). In that example, the tax assessment (and therefore accrual) date was July 1 each year, and in 1961 California changed the law to move the assessment date from July 1, 1962 to December 31, 1961. But for IRC section 461(d), taxpayers, under the accrual method of accounting, would have been entitled to accrue and deduct, for the federal tax year 1962, the state tax assessed on both July 1, 1962 (for the 1961 California tax year) and December 31, 1962 (for the 1962 California tax year), because of the change in the law.
The California franchise tax is imposed on every corporation doing business in California for the privilege of exercising its corporate franchise in California. See Cal. Rev. & Tax. Code § 23151(a). Federal case law had held that although the pre-1972 California franchise tax was measured by the preceding year’s net income, it did not accrue until the taxable (or next year). The Tax Court found a 1972 amendment to the California statute changed the accrual date for all California franchise taxpayers from January 1 of the taxable year to December 31 of the income year (preceding year).
The Tax Court concluded the effect of the 1972 California amendment was to accelerate the accrual of franchise tax to an earlier tax year, and found that IRC section 461(d) expressly addresses the type of legislation enacted by California in the form of the 1972 amendments to its franchise tax law. Accordingly, the 1972 California amendment could not be used to accelerate the accrual of California franchise tax. (But for IRC section 461(d), the court pointed out, a corporation would be entitled to two franchise tax accruals in the first effective year of the 1972 amendments.) The Tax Court commented the taxpayer’s "idiosyncratic circumstances" occurred because of the convergence of its 1987 short year and the December 31, 1988 accrual of its 1988 short federal tax return, and the result in Schwab I. However, the Tax Court concluded those unique circumstances did not support different treatment for the taxpayer than would be afforded to other California corporate franchise taxpayers for the taxable years following taxpayer’s unique initial circumstances for 1987–1989. The Tax Court acknowledged the "anomalous result," i.e., that no California franchise tax deduction is allowable for 1989, but showed little sympathy by concluding there is nothing in IRC section 461(d) that suggests "that a taxpayer is guaranteed a tax accrual in every taxable year."
While the convergence of the unusual facts in the case and the result in Schwab I makes Schwab II a decision that should have little affect upon the typical corporate federal taxpayer attempting to deduct California franchise tax, the Tax Court’s conclusion that a taxpayer is not guaranteed a tax accrual in every taxable year may have some application to other situations. Accordingly, the decision is of interest, in view of the rarity of federal tax cases that address the deductibility of California franchise taxes.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
© Morrison & Foerster LLP. All rights reserved
