Accrual of California franchise tax liabilities.

• Author: Tingey, Dennis

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 taxpayer's 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 taxpayer's final year; as a result, the taxpayer's 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 Court's and IRS's 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...