Accrual of California Franchise Tax Liabilities

More than 40 years ago, Congress enacted Sec. 461(d), primarily to prevent the states from changing their property tax lien dates to provide their citizens with a double deduction of property taxes in a single tax year. However, application of this seemingly sensible provision to California franchise tax liabilities has resulted in one of the most confusing and misunderstood tax accounting rules.

Sec. 461(d) provides:

In the case of a taxpayer whose taxable income is computed under an accrual method of accounting, to the extent that the time for accruing taxes is earlier than it would be but for any action of any taxing jurisdiction taken after December 31, 1960, then, under regulations prescribed by the Secretary, such taxes shall be treated as accruing at the time they would have accrued but for such action by such taxing jurisdiction.

Although the statutory language is somewhat difficult to understand, it is not nearly as confusing as the application of this provision to California franchise tax liabilities.

Historical Application

Historically, a taxpayers California franchise tax liability for a particular year was based solely on the income that it earned in the prior year. However, for tax years beginning after 1971, California enacted an additional franchise tax in a taxpayers final year; as a result, the taxpayers California franchise tax liability in that year was based on its prior-year income, as well as its current-year (i.e., final year) income. In reviewing the Federal income tax consequences of these legislative changes, the IRS and the Tax Court concluded that the 1972 change triggered an application of Sec. 461(d); see Rev. Rul. 79-410; Epoch Food Service, Inc., 72 TC 1051 (1979); and Hitachi Sales Corp. of America, TC Memo 1992-504.

In effect, these authorities held that following the 1972 law changes, Sec. 461(d) required taxpayers to defer accruing their California franchise tax liability until the franchise year to which the tax related, despite the fact that all events had occurred to establish the fact of the liability in the year the income on which the tax was based was earned (the lag method). Although the Tax Courts and IRSs analysis of this issue may have been subject to question, the application of Sec. 461(d) to California franchise tax liabilities in this manner appeared somewhat reasonable.

Modifications

In 1996, the Tax Court modified the blanket application of Sec. 461(d) to California franchise tax liabilities when it concluded that Sec. 461(d) did not require a taxpayers California franchise tax accrual to be deferred in its first two years of operation (The Charles Schwab Corp., 107 TC 282 (1996)). In reaching this conclusion, the court relied on the unique computation of California franchise tax liabilities under pre-1961 law. Further complicating the issue, it held that the misapplication of Sec. 461(d) to these years was not an accounting method, because the taxpayer had relied on Rev. Rul. 79-410 and its initial misconstruction of the facts in reliance on [the governments] revenue ruling should not be viewed as a method of accounting other than the accrual method. Applying [the taxpayers] method of accounting to the correct facts is not a change in accounting method requiring [the governments] approval.

Adding further complexity, California amended its franchise tax statutes for tax years beginning after 1999. These statutory changes eliminated the historic lag between the income year on which a tax is computed and the franchise year to which the tax relates. Accordingly, a taxpayers California franchise tax for a particular year is now based on the income generated in that same year. Under the accrual principles outlined in Rev. Rul. 79-410, Epoch Food Service and Hitachi Sales Corp., these changes in the computation of Californias franchise tax appear to have effectively eliminated the historic application of Sec. 461(d) to California franchise tax liabilities. That is, the traditional accrual event for a particular franchise tax liability (the exercise of the corporate franchise in the franchise year) is now computed based on income earned in that same year.

Recent Developments

In addressing the application of Sec. 461(d) to California franchise tax liabilities following the 2000 law changes, the Service adopted an unusual approach. In Rev. Rul. 2003-90, it redefined what it believed represented the pre-1961 accrual event of California franchise tax liabilities. That ruling holds that under pre-1961 California law, the accrual of a taxpayers California franchise tax liability occurred in the taxable year that follows the taxable year in which [the taxpayer] earns the income on which the tax is measured. This description of the pre-1961 accrual event is quite different from the exercise of the corporate franchise accrual event as originally stated in Rev. Rul. 79-410. Rev. Rul. 2003-90s new definition of the pre-1961 accrual event also departs from the description of the pre-1961 accrual event as outlined in the various judicial authorities referenced above.

Apparently, the IRS advanced Rev. Rul. 2003-90s unusual articulation of the pre-1961 accrual event to preserve the Sec. 461(d) deferral of California franchise tax liabilities following the 2000 law changes. Under Rev. Rul. 2003-90, Sec. 461(d) prohibits taxpayers from accruing their California franchise tax liabilities until the tax year after both the income year and the franchise year to which the tax relates. Consequently, Rev. Rul. 2003-90s unusual articulation of the pre-1972 California franchise tax accrual event adds to the uncertainty surrounding an already confusing provision.

Further, earlier this year, the Tax Court ruled in The Charles Schwab Corp., 122 TC No. 10 (2004), that although no lag of the California franchise tax deduction was required in the taxpayers first two tax years, Sec. 461(d) required accrual of the liability to be deferred in year three, causing the taxpayer to recognize no California franchise tax deduction in that year. However, in the recent Schwab case, the court applied Sec. 461(d) to the accrual of California franchise tax liabilities under pre-2000 California law. Accordingly, the case provides no precedential guidance as to how a court would apply Sec. 461(d) to the accrual of California franchise tax liabilities following the 2000 California law changes.

Conclusion

Where does this leave taxpayers? Accepting the authorities referenced above as good law, it would appear that for Federal income tax purposes, Sec. 461(d) currently operates to defer accrual of California franchise tax liabilities to the tax year that follows the tax year in which the taxpayer earned the income on which the tax is measured. This deferral would apply whether or not the tax relates to that particular franchise year and even if no liability is accrued in any particular year, unless the franchise tax relates to the first two years the franchise is exercised (in which case, the tax should be accrued in the franchise year to which it relates). This appears to be the rule, at least until either the second Schwab decision is appealed or taxpayers directly challenge the IRSs reasoning in Rev. Rul. 2003-90.

From Dennis Tingey, J.D., CPA, Phoenix, AZ