Section 461: a code section whose time has gone - d

Tax Executive, The, Jan-Feb, 1994 by Larry J. Lisses, Russell C. Nissen

The Issue

Section 461(d) of the Internal Revenue Code of 1986 is captioned "Limitation on Acceleration of Accrual of Taxes." It provides, in part:

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...then...such taxes shall be treated as accruing at the time they would have accrued but for such action by such taxing jurisdiction....

The purpose of section 461(d) is 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 the prior law. The statutory provision was originally intended to prevent the acceleration of property tax deductions. It has, however, been applied to the accrual of income taxes. As a result, California taxpayers-as well as others--bear an inequitable federal tax burden. In addition, the specific deduction requirements of section 461(d) create unusual and impractical results. With the addition of section 461(h)'s economic performance standard to the Code in 1984, taxpayers are provided by law and regulation with specific guidance on when all types of taxes are deductible. Section 461(d), hence, is a section of the Code whose time has come: It should be repealed.

The Harsh Result in Rev. Rul. 79-410

To place this issue in perspective, it is necessary to review the law and regulations as they existed prior to the 1984 enactment of section 461(h). The California Bank and Corporation Franchise Tax (CFT) is an annual tax imposed for the privilege of doing business in the State. Its treatment under the prior law and regulations is well summarized in Rev. Rul. 79-410, 1979-2 C.B. 213. The Law and Analysis section of the ruling discusses how section 461 (prior to its amendment in 1984) applies to the CFT. Section 461 is entitled "General Rule for Taxable Year of Deduction" and subsection (a) of section 461 provides that "[t]he amount of any deduction or credit allowed by this subtitle shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income." Rev. Rul. 79-410 concludes that the CFT, as it existed prior to 1966 and 1972, was (in whole prior to 1966 and in part prior to 1972) a "prepaid" tax. Thus, the CFT based on income in year 1 was levied for the privilege of doing business in year 2 (the "privilege year"), and the tax based on the income in year 2 was for the privilege of doing business in year 3, and so on.

Under this analysis, the CFT accrued on the books during year 1 was, pursuant to section 461, properly chargeable to a prepaid asset account and not deductible until the subsequent "privilege" year. For years subsequent to 1971, California law no longer calls for the "prepayment" of the CFT and Rev. Rul. 79-410 appropriately concludes that (under the general rule of section 461) the tax expense for CFT accrues in the "income year" on which that tax is based. Thus, the CFT is no longer chargeable to a prepaid account with the deduction deferred until the "privilege year" but rather is appropriately a current expense in year 1 as accrued in year 1. As such, it should be deductible in year 1.

And it would be, except for section 461(d). As previously noted, section 461(d) is intended to prevent a change in state law from triggering the acceleration of the federal deductibility of a tax expense. In the case of the CFT, absent section 461(d), the 1972 change in the CFT law would have caused both the 1971 and the 1972 CFT to accrue for federal tax purposes in 1972. Under section 461(d), however, taxpayers were required to continue deducting the CFT as though the 1972 (and other post1960) law changes did not occur. Thus, Rev. Rul. 79-410 concludes that even though the California law had changed, taxpayers must continue deducting the CFT as though the tax is a prepayment for doing business in the upcoming year (the "privilege year" method).

Rev. Rul. 79-410 goes one step further. Using the term "California tax year" to describe the year in which CFT is deductible under pre-1972 California law, the ruling concludes:

For federal income tax purposes the California franchise tax continues to accrue in the California tax year. This is true for corporations that were subject to the tax prior to 1972 and corporations commencing the conduct of business in California after 1971....(Emphasis added.)

In other words, the CFT is never deductible by an accrual basis taxpayer under any method other than that which was proper under California law as it existed prior to the 1966 and 1972 changes. This conclusion is based on Treas. Reg. [section] 1.46-1(d)(1), which provides:

Any such action which, but for the provisions of section 461(d) and this paragraph, would accelerate the time for accruing a tax is to be disregarded in determining the time for accruing such tax for purposes of the deduction allowed for such tax. Such action is to be disregarded not only with respect to a taxpayer (whose taxable income is computed under an accrual method of accounting) upon whom the tax is imposed at the time of such action, but also with respect to such a taxpayer upon whom the tax is imposed at any time subsequent to such action....(Emphasis added.)(1)