WHY do we use the "lag method" to deduct California Franchise Taxes?

I once got a call (on behalf of another CPA) asking WHY an accrual-basis taxpayer's deduction for California Franchise Taxes ("CFT") must be taken on the "lag method."

In short, the "lag method" involves taking a deduction for the CFT in the year following that in which the taxable income arose from which it was determined (e.g., CFT computed at $100x earned in 20x1, times 8.84% is $8.84x and is deductible in 20x2 for federal income tax purposes).  While this rule has applied for many years, the reason for it doesn't seem to be widely known.

In a nutshell, the CFT deduction is subject to the “lag method” for federal tax purposes due to Internal Revenue Code section 461(d).  But wait, you say...section 461(d) doesn't say anything about CFT!  All it says is the following:

461(d) Limitation on acceleration of accrual of taxes.

      (1) General rule. - 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.

      (2) Limitation. - Under regulations prescribed by the Secretary, paragraph (1) shall be inapplicable to any item of tax to the extent that its application would (but for this paragraph) prevent all persons (including successors in interest) from ever taking such item into account.

So what does the above text have to do with delaying the deduction for CFT?  Well, it goes back to the general rules for timing (section 461) as well as a bit of history.

At the risk of boring some readers, a bit of background is warranted here.  Any accrual-basis taxpayer wishing to take an expenditure into account (whether deducting or capitalizing it) must first meet the all events test.  Moreover, such item cannot be taken into account until there is economic performance.

Section 461(h)(4) provides that "the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy." In other words, the liability in question (e.g., for the tax owed to California) must (1) be unconditionally due to the person to whom it's owed, and (2) must be able to be reasonably determined as of the day it's to be taken into account (i.e., generally the last day of the tax year).

Section 461(h)(2) and Treas. Reg. section 1.461-4 provide the rules for determining when economic performance occurs.  In the case of taxes, economic performance occurs when those taxes are paid, in keeping with Treas. Reg. section 1.461-4(g)(6).

Based on the section 461 rules above, why wouldn't the CFT be properly accrued as of the last day of the year?  After all, at year-end isn't (1) the tax reasonably ascertainable, (2) the amount unconditionally due, and (3) assuming estimates were paid throughout the year economic performance was met (or the taxpayer had adopted the recurring item exception of section 461(h)(3) and Treas. Reg. section 1.461-5)?

The answer, is currently yes, but used to be no. And that's where the history comes in.  

You see, in the early 1970s, California modified its franchise tax regime which imposed a tax on most corporations doing business in the state.  Before this change, a corporation's franchise tax would be measured on the corporation's current-year income, but would apply to the exercise of its corporate franchise (i.e., the right to do business in California) starting with the first day of the corporation's following year.  As a result:

• All events test met (unconditionally due):   No, because the tax was not owed until the company started exercising its corporate franchise on the first day of the next year.
• All events test met (reasonably ascertainable):   Yes, since taxable income and the tax rate were "knowable" at year-end.
• Economic performance met:  Presumably Yes, as noted above.

In doing so, California took action (after 12/31/1960) that effectively accelerated the accrual date of the CFT.  This invoked section 461(d)(1), thereby negating that acceleration for federal income tax purposes.

So there you have it.


Final notes:  

• Too often, taxpayers (and their tax professionals) don't fully understand the rules for claiming deductions in the correct year.  That means write-offs are sometimes being taken too early and sometimes too late.
• The CFT tax deduction is just one example of how the "income tax accounting" rules can be surprisingly complicated and counterintuitive.
• I spent considerable time in KMPG's Washington National Tax practice and have personally seen how timing issues can have a multi-million dollar tax impact on someone's tax bill.  Moreover, timing issues exist in virtually every industry and area of tax, so knowing the rules and how to apply them will (literally) affect most individuals and businesses.  Let me know how I can help you (or your advisor) navigate this often-misunderstood area and avoid costly mistakes!

For more discussion of this rule, the following are enlightening.

• Rev. Rul.  2003-90 (http://www.irs.gov/pub/irs-drop/rr-03-90.pdf)
• Wells Fargo & Co. v. U.S., No. 09-CV-2764 (D. Minn. 8/10/12) (http://www.gpo.gov/fdsys/pkg/USCOURTS-mnd-0_09-cv-02764/pdf/USCOURTS-mnd-0_09-cv-02764-5.pdf)

Unrealized Built-in Gains and Losses Under Section 382 and the Tax Accounting Rules

Originally published in The Tax Adviser, November 2010  [http://www.aicpa.org/Publications/TaxAdviser/2010/November/Pages/clinic_nov10-story-10.aspx]

Many practitioners already know that section 382 generally limits the use of a corporation’s net operating losses (NOLs) in cases where there is an increase in ownership of more than 50 percentage points by one or more 5% shareholders during a three-year testing period.

Many practitioners also know that section 382 addresses cases in which corporations have either net unrealized built-in gains (NUBIGs) or net unrealized built-in losses (NUBILs) as of the ownership change date. In such cases, under section 382(h) generally,

1. For corporations with NUBIGs, a year’s section 382 limitation is increased by recognized built-in gains for that year during the five-year recognition period following the change or
2. For corporations with NUBILs, recognized built-in losses for a year during the five-year recognition period following the change are treated as if they were pre-change NOLs.

Section 382(h)(3)(A) defines the terms NUBIG and NUBIL as the amounts by which the fair market value (FMV) of the corporation’s assets immediately before an ownership change is more or less, respectively, than the aggregate adjusted basis of such assets at such time.

Interestingly, what practitioners and taxpayers sometimes do not consider is section 382(h)(6)(C)’s requirement that NUBIGs and NUBILs must generally be further adjusted for items of accrued income and accrued deductions attributable to the pre-change period (to the extent not already recognized as of the change date).

This provision can yield unexpected results (sometimes good, sometimes bad). As shown in Example 1, it can mean that a corporation that at first appears to have a NUBIL might actually have a NUBIG. Alternatively (as shown in Example 2 below), given a seemingly minor factual difference, it can mean a corporation that at first appears not to have a NUBIL might not be able to avoid having one.

Example 1: All amounts are determined as of the change date (December 31, year 1). Legal settlement accrual is reasonably ascertainable in amount but is not agreed to or paid until January 5, year 2 (i.e., neither the all-events test of section 461(h)(4) nor economic performance per section 461(h)(1) is met as of the change date).

The corporation has a net unrealized built-in gain of $1.7 million, computed as follows (see exhibit below):

• Intangible: The FMV exceeds the basis by $2 million.
• Land: The basis exceeds the FMV by $300,000.
• Accrued legal settlement (related to a tort): This $3 million amount is excluded from the calculation because it did not represent a proper accrual (aside from required economic performance) as of the change date. Therefore, it is not treated as being attributable to the pre-change period and is not a component of any NUBIG or NUBIL.

Example 2: All amounts are determined as of the change date (December 31, year 1). Legal settlement accrual is reasonably ascertainable in amount and is agreed to but is not paid until January 5, year 2 (i.e., the all-events test is met as of the change date, with economic performance occurring after the change date). Pre-change NOLs are $500,000. The section 382 limitation is $1 million.

The corporation has a net unrealized built-in loss of $1.3 million, computed as follows (see exhibit below):

• Intangible: The FMV exceeds the basis by $2 million.
• Land: The basis exceeds the FMV by $300,000.
• Accrued legal settlement (related to a tort): This $3 million amount is included in the calculation because the deduction was a proper accrual at the change date under the all-events test but was deferred until paid under section 461(h)(2)(C). Therefore, it is treated as being attributable to the pre-change period and is a component of any NUBIG or NUBIL.

This means that the deduction (to the extent of the NUBIL of $1.3 million) is lumped together with the corporation’s pre-change NOLs and (in this case) is subject to the section 382 limitation as a realized built-in loss.

Exhibit

	Tax Basis	Fair Market Value	Difference
Assets
Intangible	0	2,000,000	2,000,000
Land	2,000,000	1,700,000	(300,000)
Liabilities
Accrued legal settlement (tort)			(3,000,000)

Using the numbers above, there would be a post-change deemed NOL of $1.8 million (pre-change losses of $500,000 plus $1.3 million of realized built-in losses), which could only offset income in the subsequent year (December 31, year 2) of up to the $1 million section 382 limitation, with the remainder ($800,000) of the disallowed realized built-in losses being carried forward under the rules applicable to NOLs.

While these two examples are admittedly simple (and focus only on accrued deductions), they do make one thing clear—corporate tax practitioners must pay close attention not only to the unrealized gains and losses inherent in a corporation’s assets when facing a section 382 limitation, but also to those less-obvious items of accrued income and expense. In fact, the author was approached about a year ago by another practitioner on a matter fairly similar to Example 1 above, where the numbers were many times higher than those given here. As a result, what initially looked like a large NUBIL instead turned out to be a substantial NUBIG, much to the relief of all involved.

Bottom line: Don't forget to consider the tax accounting method rules (for accrued income or expense items) when dealing with section 382.