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October 15, 2012

In what taxable period is an accrual-basis taxpayer allowed a deduction on its federal tax return for state franchise taxes? You'd think the answer to this question would be relatively straightforward compared to other complex tax issues we're regularly faced with. Well think again, my fellow tax professionals. Whenever we're presented with facts that require making sense of the interaction of an obscure provision buried in the Internal Revenue Code with state and local tax provisions, our "simple" question in fact raises many more questions.

Accruing Taxes ---- The Basics

Section 164 of the Code allows a deduction for certain taxes paid or accrued during the tax year. The accrual of income, franchise and similar taxes is subject to the provisions of Section 461 of the Code and regulations thereunder, which deal with the "all events test" and "economic performance." Generally, under these rules, an accrual-method taxpayer cannot deduct income, franchise and similar taxes until economic performance has occurred (i.e., until such taxes have been paid). However, an exception (e.g., the recurring item exception) may apply that allows a taxpayer to deduct income, franchise and similar taxes where the economic performance test hasn't been met. If an exception does apply, a taxpayer can deduct a tax when all of the events that determine the fact of the liability have occurred and when the amount of the liability can be determined with reasonable accuracy.

Now, for the "not-so-basic" provision. Under Section 461(d) of the Code, for an accrual-method taxpayer, to the extent the time for accruing a tax is earlier than it would have been but for any action of any taxing jurisdiction taken after 1960, the tax is treated as accruing at the time it would have accrued but for the action by the taxing jurisdiction. In other words, if a state decides to change its tax laws after 1960 ---- and, as a result of that change, the accrual date of the payment of state taxes is accelerated ---- then the change in the state tax laws is ignored for purposes of federal tax law. The rationale for enacting Section 461(d) was to prevent a change in a taxing authority's law (other than a federal law) from causing the acceleration of the deductibility of a tax expense into an earlier year than that which would have been the case under pre-1961 law. Read on folks and you'll learn how this "obscure" provision can bite unsuspecting taxpayers.

California Bank and Corporation Franchise Tax

California assesses tax for the privilege of doing business in the state. The amount of tax is based on the corporation's income in a particular year ("Year 1"); however, the tax is paid for the privilege of conducting business in the following year ("Year 2"). Pre-1972, the amount of a corporation's tax liability was reduced if it stopped doing business in California at some point during Year 2, and if the corporation did not do any business in California in Year 2, the corporation wouldn't have any tax liability at all. In 1972, California changed its tax laws on corporations doing business in the state. Since 1972, a corporation must pay taxes for the right to do business in Year 2 with no "escape" provision allowing for a reduction in its liability if the corporation reduced or eliminated its business activity in California during Year 2.

I think we can guess where this is heading. Both the Tax Court and the Ninth Circuit have recognized that as a result of California's 1972 law change, a corporation that met the "all events" test could deduct the California taxes in Year 1 were it not for Section 461(d)1footnote1. However, under Section 461(d), the 1972 change in California law is ignored when analyzing whether the "all events" test is met. The analysis is driven by California law in effect pre-1961.

The Wells Fargo Case2footnote2

Every year, Wells Fargo would pay its fair share of California state taxes for the privilege of doing business in California. As described above, the amount of such taxes is based on Wells Fargo's income in a particular year (i.e., Year 1); but the state taxes are paid for the privilege of conducting business in the following year (i.e., Year 2).

Up until 2003, Wells Fargo regularly took a deduction for the taxes that it paid in Year 1 for the privilege of conducting business in California in Year 2 on the federal tax returns that it filed for Year 2. Wells Fargo filed an election to change its method of accounting for deducting these taxes effective for its 2003 tax year contending that, as an accrual-method taxpayer, it ought to be able to take a deduction for the California taxes on the federal tax returns that it files for Year 1. According to Wells Fargo, it should be able to deduct the taxes in Year 1 because, even though they are paid for the privilege of conducting business in California in Year 2, the obligation to pay those taxes and the amount of those taxes becomes "fixed" by the end of Year 1. In addition, Wells Fargo actually pays the taxes (in the form of estimated taxes) during Year 1.

Both Wells Fargo and the government agreed that if Wells Fargo's tax treatment depended on California law as it has existed since 1972, then Wells Fargo would be able to take a deduction for its payment of California taxes on its Year 1 return because its liability for those taxes would become "fixed and absolute" in Year 13.footnote3 The Minnesota District Court referred to the Tax Court and the Ninth Circuit, who had recognized that as a result of California's 1972 law change, a corporation that met the "all events" test could deduct the California taxes in Year 1 were it not for Section 461(d). However, Section 461(d) renders the 1972 change in California law irrelevant. What matters is California law as it existed before 1961, and both the Tax Court and the Ninth Circuit have stood by their precedent interpreting pre-1961 California law to require that the deduction be taken in Year 2.

Wells Fargo wasn't done yet. Wells Fargo and the government agreed that, by virtue of Section 461(d), Wells Fargo's ability to take a deduction for California taxes turns on California law as it existed before 1961. They, however, were not in agreement with the aforementioned precedent established by the Tax Court and the Ninth Circuit that under California law as it existed prior to 1961, businesses in the position of Wells Fargo could not take a deduction for California taxes until Year 2. Wells Fargo was relying primarily on the Supreme Court's application of the "all events" test in Hughes Properties4footnote4 to support its position. Thus, the decision ultimately came down to whether the Wells Fargo case was distinguishable from Hughes Properties in the application of the "all events" test.

Hughes Properties

In Hughes Properties, the taxpayer was a Nevada casino that operated progressive slot machines. Each time the slot machine lever is pulled, the amount of the jackpot for a progressive slot machine increases. Nevada regulations prohibit casinos from reducing the jackpot before it is won and require casinos to keep a cash reserve sufficient to pay the jackpot when it is won. Casinos have carried the amounts of the progressive jackpots on their books as an "accrued liability."

The casino in Hughes Properties attempted to deduct the net year-to-year increase in its accrued progressive-jackpot liability. The government said "no" and disallowed the deduction on the grounds that the casino did not incur any liability until a player actually won the jackpot. The government argued that if the casino surrendered its license or filed for bankruptcy, there would be no creditor to claim the jackpot. Thus, in the government's eyes, the "all events" test wasn't met during the tax year because the "fact of the liability" had not yet been established.

The Supreme Court rejected this argument. The effect of the Nevada regulations was to "irrevocably fix" the casino's liability for the jackpot, the Court said. The only unknowns were timing of payment (not relevant for accrual-method taxpayers) and the identity of the ultimate winner (again not relevant). The Supreme Court did note the remote possibility that the jackpot would never be won, but treated that as so speculative and unlikely as not to be worth taking into account. As to the government's argument that the casino could avoid liability by going out of business or declaring bankruptcy, the Court commented:

There is always a possibility, of course, that a casino may go out of business, or surrender or lose its license, or go into bankruptcy, with the result that the amounts shown on the jackpot indicators would never be won by playing patrons. But this potential nonpayment of an incurred liability exists for every business that uses an accrual method, and it does not prevent accrual.


The Minnesota District Court acknowledged the "closeness" of the question and that good points were made on both sides. But in the end, the Court predicted that, if appealed, the Eighth Circuit would find Hughes Properties distinguishable and would ultimately align itself with the longstanding position of the IRS5footnote5, the Tax Court, and the Ninth Circuit. The Court reached its conclusion because, in its view, it appeared that the obligation of the casino in Hughes Properties was "materially different" from the obligation of a business under pre-1961 California tax law.

The Supreme Court concluded in Hughes Properties that the effect of the Nevada Gaming Commission's regulations was to "fix" the casino's liability. The Court concluded that the actual event that would determine the fact of the liability was not the payment of the jackpot, but "the last play of the machine before the end of the fiscal year." The Court acknowledged that future events (e.g., the casino closing or losing its license) might mean that, as a practical matter, the casino would not pay its progressive-jackpot liability, but the liability itself, the Court said, was "definitely fixed" as of the end of the tax year.

The obligation of a business in California prior to 1961 appeared different to the Minnesota District Court. The business would never become liable to pay for the privilege of operating in Year 2 unless it actually operated in Year 2. The corporation's legal obligation to pay taxes for the privilege of conducting business in California in Year 2 was thus "contingent" on its actually conducting business in California in Year 2. The "actual event that would create the liability" was not anything that happened in Year 1, but the corporation's doing business in California in Year 2. Although the business had been required in Year 1 to essentially "prepay" the taxes that it expected to become liable for in Year 2, its liability for California taxes did not become "fixed and absolute" until the last day of Year 2. If a corporation did no business in California in Year 2 it had no liability to pay taxes to the State of California ---- full stop.

In contrast to Hughes Properties, it was the continued operation of the business in Year 2 that fixed the fact of the liability for taxes under pre-1961 California law. To be liable, the business not only had to operate, but it had to operate in Year 2. For these reasons, the Minnesota District Court sided with the government as well as the Tax Court and the Ninth Circuit in finding that since (under pre-1961 California law) Wells Fargo's liability for the California taxes does not accrue until it operates during Year 2, Wells Fargo cannot take a deduction for California taxes in Year 1.

Alvarez & Marsal Taxand Says:

As evidenced by various decisions and rulings in this area, it is critical before taking your deduction for state taxes on your federal tax return to be aware of the interplay between Section 461(d) and the plethora of state and local tax laws that could result in its application. The popular view is that the precedent Wells Fargo was attempting to challenge will live on. Case in point is the IRS's position in Chief Counsel Advice (CCA) 200949040 relating to the timing of deductions for accrued bonuses. The IRS concluded that the "all events" test hadn't been met in Year 1, since the employees were required to be on the payroll at the time of payment in Year 2. Not unlike the Wells Fargo case, some event had to occur in Year 2 for the fact of the liability to become "fixed and absolute." In the CCA, the employees had to continue providing services in Year 2 in order to collect their bonus relating to services rendered in Year 1; and in Wells Fargo, the business had to continue to operate in Year 2 for it to be liable for California franchise tax (under pre-1961 California law), which was calculated based on Wells Fargo's income earned in Year 1. 


1 See Charles Schwab Corp. v. Comm'r, 495 F.3d 1115, 1119 [100 AFTR 2d 2007-5420] (9th Cir. 2007); Epoch Food Serv., Inc. v. Comm'r, 72 T.C. 1051, 1054-55 (T.C. 1979). 

2Wells Fargo & Company v. U.S., (DC MN 8/10/2012) 110 AFTR 2d 2012-5552. 

3 See Brown v. Helvering, 291 U.S. 193, 201 [13 AFTR 851] (1934). 

4 United States v. Hughes Properties, Inc., 476 U.S. 593 [58 AFTR 2d 86-5062] (1986). 

5 See Rev Rul 79-410, 1979-2 CB 213; Hitachi Sales Corp. (1992) TC Memo 1992-504; Rev Rul 2003-90, 2003-33 IRB 353 amplifying Rev Rul 79-410, 1979-2 CB 213.


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