Navigating the Minefield of the Internal Revenue Code | Big Fat ...

The Federal Tax Code is riddled with landmines. These ?traps for the unwary? are a major source of the complexity about which American businesses complain. One such trap is illustrated by a recent case involving the timing of Federal tax deductions for California state income taxes paid by Wells Fargo bank.

Accrual method taxpayers normally deduct a liability (such as a state income tax) in the year in which the ?all-events test? is met. That test requires that (1) all the events that establish the fact of a liability have occurred, and (2) the amount of that liability is determinable with reasonable accuracy. In most cases, actual payment meets the all-events test.

California?s income tax is actually a tax on the privilege of conducting business in the state. The tax must be paid on Year 1 income for the privilege of conducting business in the state in Year 2. Under current law, the event that fixes the Year 1 tax liability is the actual Year 1 tax liability and the payment of the tax. So a corporation could reasonably conclude that the Year 1 taxes would accrue and would, therefore, be deductible for Federal income tax purposes in Year 1.

Before 1972, however, California law provided that the Year 1 tax could be reduced if and to the extent that the taxpayer did not conduct business in California in Year 2, so the event that fixed the liability and determined its amount was the conduct of business in Year 2. This is important because an arcane provision in the Federal Tax Code?specifically, section 461(d)?provides that if a state changes its law after 1960 and, as a result of that change, moves up the accrual date for the payment of taxes, then the change in state law is ignored for Federal tax law purposes. Notwithstanding that a corporation paid Year 1 income tax in Year 1 (for example, through estimated payments), section 461(d) requires that a corporation cannot deduct its California income tax on its Federal return until Year 2.

As is often the case with what appears at first blush to be a silly rule, there was reason in Congress? madness in enacting section 461(d) in 1960. It appears that several states had changed their lien date for the imposition of property taxes?and, thus, the accrual date for the taxes?from January to December of the previous year to provide taxpayers with an extra accrual date. Congress thought that this would improperly allow a taxpayer to deduct the same payment twice, and justifiably sought to make that impossible. The language that Congress used, however, was broad enough to catch the subsequent change in California income tax law.

This example illustrates why it is so dangerous to navigate the Internal Revenue Code unaided. Well-prepared taxpayers should arm themselves with the latest detection equipment in the form of expert guides so that they can complete their journey safely.

Any tax advice contained herein was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding U.S. federal, state, or local tax penalties. You should consult with your professional tax advisor to discuss the potential application of this subject matter to your particular facts and circumstances.

Source: http://bigfatfinanceblog.com/2012/08/27/navigating-the-minefield-of-the-internal-revenue-code/

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