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Way back near the end of May, which feels like a very long time ago, we published a couple of pages of overview on how to classify ownership interests in activities as passive vs. non-passive.  Somewhere in that article I promised to mention how real estate interests can qualify as non-passive activities.

This determination is key in the proper treatment of income and losses both for the purposes of the limitations under the passive activity loss rules and also for the inclusion in the calculation of the new Net Investment Income tax.

For an activity to be considered non-passive, the owner must materially participate in that activity and generally meet one of seven tests enumerated in Reg. Section 1.469-5T, explained previously.  Despite those requirements, rental activities are per se passive, that is, automatically treated as passive regardless of the level of the owner’s participation.  There are a couple of exceptions to that default which we mentioned in the earlier article for self-rental activities, holding a working interest in an oil and gas property, and where a grouping election would be allowed with a non-rental activity in only specific circumstances. However, the most frequently used (and risky) exception to the default treatment of real estate income or loss as passive is when an election is made for a real estate professionals.

Special rules are provided under IRC §469(c)(7) for rental activities commonly referred to as the real estate professional rules.  If the test is met, the rental activity of a real estate professional is treated as non-passive.  Treatment as non-passive is advantageous when a real estate rental activity is generating losses that can be used to offset other income such as interest, dividends and wages.  Conversely, the passive losses would not reduce other passive real estate income for purposes of the net investment income tax.  Planning to make this election should be well thought out in that it may not always be desirable to treat net rental real estate income or loss as non-passive and the election itself may invite increased IRS scrutiny.

Am I a real estate professional?

The real estate professional must satisfy two tests:

  • more than one half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
  • such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

At first glance, the test seems relatively easy to satisfy until you realize that for an activity to be counted towards the first and second test, the owner must materially participate in each activity to treat the income or losses as non-passive.  If there are interests in several real estate activities, this may be difficult to satisfy.  To help satisfy the material participation for each activity, a special grouping election can be made under Reg. Section 1.469-9 to treat all interests in rental estate as one activity. Once made, the election is binding for all future years the taxpayer is a qualifying real estate professional and is revocable only if there is a material change in facts and circumstances.  In case you missed the election, one can be filed with an amended return under Rev. Proc. 2011-34.

The rental estate activity is owned by a trust.  Can the trust be a real estate professional?

The Code nor the regulations address how material participation rules can be satisfied for taxpayers who are trust, estate or personal service corporations.  Under IRC §469(c)(7)(B) the requisite amount of service hours must be performed in real property trades or businesses, the performance of which the IRS has previously stated must be by a taxpayer who is a natural person and has the capability for physically performing such services.  In looking to case law for guidance, the U.S, Tax court in a recent decision, held that a trust taxpayer could meet the material participation standards through the performance of its trustees and thus qualify for the real estate professional exception under §469(c)(7). [Frank Aragona Trust, (2014) 142 TC No. 9.] In the case, the taxpayer was a trust that owned rental real estate properties and engaged in other real-estate activities.  The court ultimately rejected the IRS’ argument that a trust is incapable of performing personal services.  Rather, the Tax Court held that the trust is an arrangement whereby trustees have a fiduciary responsibility to manage assets for the benefit of the trust’s beneficiaries and therefore worked performed by an individual as part of their trustee duties are personal services for purposes of satisfying the section 469(c)(7) exception.

The trust was formed by a grantor who, after his death, was succeeded as trustee by his five children and one independent trustee.  All six trustees acted as a management board for the trust and made all major decisions regarding the trust’s property. In addition, a disregarded LLC, wholly owned by the trust, managed the trust’s rental real-estate properties.  The LLC employed several people, some of whom were the trustees.  The court ruled that not only were the activities performed by the individuals in their duties as trustee included as personal services performed in a real-estate trade or business, but also their time spent as employees of the LLC managing the rental real estate properties.

Because the requisite hours in real-property trades were met and the trust materially participated in the real property businesses, the trust met the exception to the per se passive treatment of rental real estate activities and was able to treat the income and losses from the activities as non-passive.

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A new chapter was added to the ongoing dispute as to whether student athletes should be compensated for (i) the part they play in helping their respective schools generate millions of dollars in revenue from ticket sales and the use of their individual player likenesses, and (ii) the predominant amount of time that is spent as an athlete as opposed to a student.  It is a deeper issue than simply framing it as “pay for play”, but that discussion is one for another day …

What is important for our purposes is that the National Labor Relations Board (“NLRB” or the “Board”) recently ruled Northwestern University’s scholarship football players (differentiated from walk-on players) are “employees” under the National Labor Relations Act (the “Act”), and as such, have the right to unionize for collective bargaining purposes.

The Board’s ruling will be appealed, so the practical application of this unionization right and the resulting sub-issues from the decision will be delayed as of this writing.  However, there are theoretical tax matters that will play a part in the debate, and that could emerge if student-athletes are in-fact deemed “employees”.  Furthermore, the reasoning that the NLRB used to reach its conclusion that student-athletes are “employees” may also be the basis for which student-athletes would be taxed.

Without going into extensive detail, the NLRB determined that the Northwestern football players receive the substantial economic benefit of a scholarship in exchange for performing football-related services, under what amounts to be a contract-for-hire.  Additionally, the Board made note of the extensive amount of control that the football coaching staff and University have over the players, and that if team rules are broken, scholarships can be revoked:

  • NCAA rules prohibit players from receiving additional compensation or otherwise profit from their athletic ability and/or reputation, so scholarship players are dependent on their scholarships to pay for basic necessitates, including food and shelter;
  • Players devote 40-60 hours per week for football, depending on whether it is in-season versus the off-season, despite the NCAA’s prescribed limitation of 20 hours per week once the academic  year begins;
  • Coaches control living arrangements, outside employment, the ability to drive personal vehicles, travel arrangements off-campus, social media, use of alcohol or drugs, and gambling;
  • Players also are sometimes unable to take courses in certain academic quarters because they conflict with scheduled team practices.

At this point it is not entirely clear what student-athletes would be taxed on because if the decision is ultimately affirmed, there could be conflicting definitions and concepts in the tax code with respect to “gross income”, “compensation for services” and “qualified scholarships.”

For income tax purposes, “gross income” means all income from whatever source it is derived, and this includes compensation for services.  Until now student-athletes have not been considered employees, which is essentially why their scholarship (or parts of) have not previously been taxed.  But the NLRB went to great lengths to detail how the Northwestern football players currently receive compensation for playing football (the reason it saw fit to classify them as employees).  On that same basis, the IRS would likely take the position that the granted scholarships are compensation for services, and are thus taxable income to the student-athletes.  Whether the current statutory language would have to be amended or exclusions would have to be created to properly allow for this taxation is a secondary issue.

Yet there are other benefits the Northwestern football players have cited which they feel would outweigh the negative impact of taxes they might incur.  If the decision is upheld, players might be able to qualify for workers’ compensation benefits as a result of injuries suffered on the field.  Moreover, instead of coaches having unilateral control over the schedules and rules players must abide by at the risk of losing scholarships, the union the players could form would bargain with the university over “working conditions”.  This would be similar to the way in which the NFL and MLB players’ unions bargain for benefits of their respective players.

However, rights that are bargained for by this theoretical union could lead to further questions for the university.  For example, if players successfully bargained for health benefits, Title IX (which demands equal treatment of male and female athletes) might require equivalent benefits to all of the other athletic programs on campus.  Conversely, bargained-for benefits such as safer football helmets or equipment would not necessitate comparable action on the part of the school.

The NLRB ruling in the Northwestern case is restricted to private universities, meaning efforts by student-athletes of state schools would be governed by each state’s laws on unions of public employees.  However, this decision is an initial step in what will be a lengthy process that ultimately could re-shape the National Collegiate Athletics Association (“NCAA”) … and tax issues will most certainly have a substantial impact along the way.

CJ Stroh, Esq.

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When the calendar turns to mid-March and tax season makes the leap from annoying to soul-crushing, I spend more time than I should daydreaming about goin’ all Walter White and breaking bad, only instead of cooking meth, I’d use my well-honed number-crunching skills to become an underground bookie.

Oh, what a life it would be. Instead of spending March Madness in a tiny office cranking out tax returns, I’d spend it in a giant war room complete with wall-to-wall flat screens, building my riches on the failed dreams of student athletes. I’d work the phone better than Gordon Gecko, avoiding detection by using subversive colloquialisms like “unit” and “juice.” I’d threaten to break thumbs with impunity. And I’d make money. Lots and lots of money. Because the house never loses.

The house doesn’t lose because it is (generally) indifferent to who the bettors favor. Not to get into Gambling 101, but if you bet $100 on the Seahawks + 2 ½ in the Super Bowl, you won $100, But if you bet $100 on the Broncos to cover the 2 ½ points (sucker), you lost $110. The $10 the loser pays over and above the wagered amount is the “vig.”

Thanks to the vig, bookies generally don’t care who people are betting on, as long as the bets are fairly even on both sides. And of course, bookies have the advantage of being able to move the line to make sure this happens.

When it comes to horse racing — which in my bookie fantasy world, I will  occasionally dabble in but not invest heavily – the house has an added level of protection in the form of “parimutuel wagering.” It works like so:

The entire amount wagered on a particular race is referred to as the betting pool or “handle.” The pool can then be managed to ensure that the track receives a share of the betting pool regardless of the winning horse. This share of the betting pool that the track keeps for itself is often referred to as the “takeout,” and the percentage is driven by state law, but generally ranges from 15% to 25%.

The takeout is then used to defray the track’s expenses, including purse money for the winning horses, taxes, licenses, and fees. The takeout can also be used, if needed, to cover any shortfall in the amount necessary to pay off winning bettors. To the extent any excess takeout remains after covering these two classes of obligations, the track has profit.

Once the betting pool has been reduced by the takeout, the balance is generally used to pay off any winning wagers, with the excess, once again, representing profits. Great business model, isn’t it?

Yesterday, an enterprising CPA with a raging gambling habit threatened to strike a blow for bettors everywhere when he took on the IRS in the Tax Court and argued that the portion of his wagers attributable to the “takeout” were deductible without limitation. But before we can understand the significance of the case, we need to understand some basics about the taxation of gambling.

Treatment of Gambling Expenses, In General

Section 165(d) provides that “losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.” Generally, any winnings are reported on page 1 of the Form 1040, while the losses (but only to the extent of winnings) must be claimed as itemized deductions. Thus, if a bettor is one of the 66% of Americans who don’t itemize their deductions, they would effectively be whipsawed – they would be forced to recognize the gambling income, but would receive no benefit from the losses.

Section 162, however, generally allows a deduction for “all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.”

Putting these two provisions together, many bettors have taken the position that if their gambling activities are so frequent, continuous and substantial as to rise to the level of an unhealthy addiction a Section 162 trade or business, then gambling losses are deductible as Section 162 business expenses, and are not subject to the loss limitations imposed by Section 165(d). In their view, if the gambling activity constitutes a business, because the losses (along with the gains) should be reported on Schedule C, rather than itemized deductions, the losses should be permitted in full.

The courts have repeatedly shot this theory down, holding that even a professional gambler who properly reports his activity on Schedule C may only deduct losses to the extent of gains.

In a very important 2011 decision out of the Tax Court, however, the court held that while gambling losses are limited to the extent of gambling winnings, any non-loss expenses of a professional gambler engaged in a trade or business – items like automobile expenses, travel, subscriptions and handicapping data – are not subject to the Section 165(d) limitation. Thus, a professional gambler could reduce his winnings to zero by his losses, and then further deduct any non-loss business expenses, generating a net loss from the activity. (See Mayo v. Commissioner, 136 T.C. 81 (2011).)

And that brings us back to our gambling CPA.  In Lakhani v. Commissioner, 142 T.C. 8 (2014), settled yesterday, an accountant/prolific track bettor made the compelling argument that his portion of the track’s “takeout expenses” represented non-loss business expenses rather than gambling losses, and were thus deductible without limitation. The taxpayer posited that by extracting takeout from the taxpayer’s wagers and using those funds to pay the track’s operating expenses, the track was acting in the capacity of a fiduciary. The taxpayer further likened the process to that of an employer who collects payroll taxes from his employees and remits them to the IRS and state agencies. Stated in another manner, the taxpayer argued that he was paying the operating expenses of the track, with the track acting as a conduit by collecting the takeout and using the funds.

Based on this position, the taxpayer argued that he was entitled to non-loss gambling business deductions in excess of $250,000 between 2005 and 2009.

The IRS disagreed with the taxpayer’s argument, countering that because the takeout is paid from the pool remaining from losing bets, “it is inseparable from the wagering transactions,” and thus constitutes wagering losses that are subject to the limits of Section 165(d). Furthermore, the Service argued that the taxpayer could not deduct business expenses for amounts paid from the takeout by the track for taxes, fees, and licenses, etc… because these were expenses owed by the track, not the individual bettor.

The Tax Court sided with the IRS, holding that the taxpayer’s share of the takeout expenses represented wagering losses that could only be deducted to the extent of winnings under Section 165(d). In reaching this conclusion, the court differentiated between an employer remitting payroll taxes on the behalf of an employee and a track using takeout funds to pay its operating expenses.

The employee, the court stated, is ultimately responsible for his share of the payroll taxes on his wages, and it is the remittance of these taxes by the employer that discharges the employee of this obligation. To the contrary, at no point are the expenses of the track imposed on the individual bettor; they are always obligations of the track. The tracks use of the takeout to pay its expenses, the court stated, does not discharge any obligation of the bettor.

As a result, the court concluded that because the track’s expenses were never an obligation or expense of the bettor, the takeout could not qualify as the bettor’s business expense. Instead, the takeout represented an additional gambling loss by the taxpayer, and could only be deducted – when added to his other losses – to the extent of his winnings.

follow along on twitter @nittigrittytax

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Guillermo Arguello worked for Guggenheim Investments, a conglomerate of entities of uncertain purpose. Mr. Guggenheim struck up a business relationship with another corporation, Netrostar, that was intended to be symbiotic: Guggenheim Investments would share customer lists and provide financing, while Netrostar would provide web development work to the Guggenheim entities.

Times got tough at Netrostar, and Arguello, who performed some small bookkeeping services for the company, was asked to help bail it out.

First, Arguello spent $24,000 on a used Alfa Romeo that was needed — for some odd reason — to keep Netrostar alive, and sold it to the company in exchange for a note.

In addition, Arguello cosigned Netrostar credit card debt in excess of $35,000.

At the end of 2007, Arguello was still owed $21,000 on the Alfa Romeo note, and he was justifiably getting antsy with his precarious position as creditor of a dying corporation. As a result, Mr. Guggenheim worked up an agreement by which Netrostar would pay Arguello an additional $2,000 towards the note, and then Arguello would “forgive” the remaining $19,000 balance in exchange for his release as cosigner of the credit card debt.

On his 2007 tax return, Arguello claimed a worthless debt deduction of $19,000. The IRS promptly denied the debt, arguing that it had not become worthless during 2007.

Relevant Law

Under Section 166, a taxpayer is entitled to a deduction for a debt, business or nonbusiness, that becomes wholly or partially worthless during the taxable year. There is no standard test for determining worthlessness; whether and when a ebt becomes worthless depends on all the facts and circumstances.[i] In general, the year of worthlessness must be established by identifiable events constituting reasonable grounds for abandoning any hope of recovery.[ii]

The Tax Court concluded that Arguello’s receivable from Netrostar did not become worthless during 2007, primarily because the debt was not forgiven due to Netrostar’s inability to pay, but rather in exchange for getting Arguello off the hook for this co-signed credit card debt:

We cannot assume, and do not find, that as of the close of 2007, Netrostar’s financial condition, although shaky, prompted petitioner to relinquish his rights to collect the balance on the note. The evidence shows, and we find, that the debt was extinguished not so much on account of Netrostar’s ability or inability to pay, but rather pursuant to an arrangement that allowed petitioner to avoid potential liabilities in connection with the credit card accounts.

The court summarized its decision thusly:  “A debt is not worthless where the creditor for considerations satisfactory to himself voluntarily releases a solvent debtor from liability.”

The takeaway lesson, of course, is that in today’s economy, where debts are being forgiven left and right, when you are on the creditor side there is a distinction between a debt becoming uncollectible and simply forgiving the debt in exchange for some form of noncash consideration. Under the tax law, the debtor must establish that the debt has become wholly or partially worthless in order to secure a bad debt deduction.


[i] Dallmeyer v. Commissioner, 14 T.C. 1282, 1291 (1950).

[ii] See Crown v. Commissioner, 77 T.C. 582, 598 (1981).

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In a case with far-reaching implications — including the potential for refund claims to be filed by any employer making severance payments to terminated employees during the recent economic downturn — the Court of Appeals for the Sixth Circuit concluded on Friday that severance pay pursuant to an involuntary layoff was not subject to FICA employment taxes.

First, a bit of history: The treatment of certain supplemental unemployment compensation benefits (“SUB”) for FICA purposes has long been clouded. SUB payments were created in the 1950s as a way to supplement the state unemployment compensation benefits received by employees upon involuntary termination, and were defined in Section 3402(o) as amounts:

1) Which are paid to an employee, 2) Pursuant to an employer’s plan; 3) Because of an employee’s involuntary separation from employment, whether temporary or permanent, 4) Resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and 5) Are Included in the employee’s gross income. [Ed note: this will encompass most involuntary severance payments.]

These SUB payments have always been subject to federal income tax withholding by virtue of that same Section 3402(o), which provides that for purposes of determining whether a SUB payment is subject to withholding, it “shall be treated as if it were a payment of wages by an employee to an employee for a payroll period.”

In the most important court decision on this issue prior to last Friday, the Court of Appeals for the Fifth Circuit had concluded in CSX Corporation v. United States, 518 F.3d 1328 (5th Cir., March 2008), that this language did not mean that SUB payments were treated as wages only for purposes of determining whether they were subject to federal income tax withholding. Rather, the court held that SUB payments were also wages for purposes of FICA taxes, stating:

…because we have rejected the first part of CSX’s argument-that the reference to the term “wages” in section 3402(o) necessarily implies that all payments falling within the definition of SUB in that subsection are non-wages, we reject CSX’s statutory argument.   Based on that analysis, we disagree with the trial court’s conclusion that all payments that qualify as SUB under the statutory definition in section 3402(o)(2)(A) are non-wages for purposes of FICA. We therefore reverse those portions of the trial court’s judgment that were based on the trial court’s adoption of that theory of the case.

On Friday, the 6th Circuit took a different approach, and reached a different conclusion, in Quality Stores, Inc. v United States, holding that severance payments were not subject to FICA.

Quality Stores was an agricultural-specialty retailer who filed for Chapter 11 during 2001. Prior to November, 2001, Quality Stores involuntarily terminated 75 employees, with all remaining employees terminated after November 2001 when Quality Stores closed its doors and went out of existence.

As part of the severance packages offered by Quality Stores, employees were paid based on years of service, and the payments were not tied to the receipt of any state unemployment compensation.Because SUB payments clearly represent income that is subject to federal income tax withholding pursuant to Section 3402(o), Quality Stores reported the payments on the recipients’ Forms W-2, and remitted over $1,000,000 in FICA tax to the IRS. Soon after, Quality Stores filed a claim of refund for the FICA taxes, arguing that the severance payments were not subject to FICA as they were not “wages” for those purposes.

In an initial hearing, a bankruptcy court ruled in favor of Quality Stores in 2005, and late last week, the 6th Circuit affirmed the bankruptcy court’s decision, holding that the SUP payments were not wages subject to FICA tax.

The 6th Circuit reached its conclusion by first looking to the legislative history of Section 3402(o). When the provision was enacted in 1969, Congress recognized that SUB payments “are not subject to federal income tax withholding because they do not constitute wages or remuneration for services.” Because SUB payments represent taxable income to the recipient, however, Congress wanted to take the income tax burden of the recipient by requiring withholding at the source, adding:

Although these benefits are not wages, since they are generally taxable payments they should be subject to withholding to avoid the final tax payment problem for employees.

Having established that SUB payments were not wages for federal income tax purposes, the Sixth Circuit then looked to prior case law, which held that Congress intended for the definition of wages for federal income tax and FICA purposes to be one and the same.[i]

Congress imposed federal income tax withholding on SUB payments because they qualify as gross income, not because they are “wages.” Reading the definitions of “wages” found in the FICA and federal income tax statutes consistently, SUB payments do not constitute “wages” under either statutory scheme.

What’s the lesson? With the Fifth and Sixth Circuit Court of Appeals disagreeing on such an impactful issue, the determination of whether SUB severance payments are wages subject to FICA is likely heading to the Supreme Court. In the meantime, it may behoove any employers who recently paid FICA tax on SUB payments to file a  protective claim for refund.


[i] See Rowan Cos. v. United States, 452 U.S. 247 (1981)

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Kerry Kerstetter conducted an accounting and tax preparation business out of his Arkansas home. When preparing his Schedule C for his personal tax return, Kerstetter made a litany of mistakes, among the more egregious of which were:

  • Deducting depreciation on his entire home, rather than the portion used exclusively and regularly for business as permitted under Section 280A.
  • Deducting all of his personal credit card interest and mortgage interest on Schedule C, rather than on Schedule A or — in the case of the credit card interest — nowhere.  
  • Deducting pet food as “supplies.”

To make matters worse, Kerstetter failed to file his 2001 and 2003 returns on time. When he did get around to filing them, the returns reflected large net operating loss carryforwards that wiped out his income, but that Kerstetter could not substantiate.

As you might expect, the Tax Court expected more from someone holding themselves out to the public in such an esteemed, trusted position as a tax advisor:

Petitioners’ arguments in this case have not been supported by evidence or by authority. Instead petitioners make assertions based only on their generalized testimony and on petitioner’s claimed years of experience in dealing with the IRS on behalf of clients. Particularly in view of petitioner’s experience, the absence of corroboration of his testimony by organized and reliable records leads us to conclude that petitioners have not carried their burden of proof as to the disputed deductions.

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Citation: Wells Fargo & Company v. U.S, (DC MN 8/10/2012) 110 AFTR 2d ¶ 2012-5188

Gather round children, whilst I tell a tale of the most widely-read but poorly-written book of all time, 50 Shades of Grey the Internal Revenue Code.

Our story is set in the destitute great state of California.  Our central figure is the national banking chain of Wells Fargo. Like all corporations operating in California, Wells Fargo pays taxes each year for the privilege of doing business within the state.  The tax is based on the income earned in Year 1, but is paid for the privilege of doing business within the state in Year 2.  Importantly, the tax is actually paid in Year 1 in the form of estimated payments.

Under California state law as it has existed since 1972, the tax Wells Fargo pays based on its Year 1 income for the privilege of doing business in Year 2 is not refundable. To illustrate, even if Wells Fargo pulled out of California on Day 1 of Year 2, it is still required to pay the tax for the right to conduct business in Year 2.

As an accrual basis taxpayer, this led Wells Fargo to believe that it could safely accrue the state tax deduction at the end of Year 1, as it would have satisfied the “all-events” test at that time.

As a reminder, meeting the all-events test is required under I.R.C. § 461 in order for an accrual basis taxpayer to deduct a liability. The all events test requires an accrual basis taxpayer to jump through three hoops:

1. The fact of the liability must be fixed. In simple terms, this means that whatever event that is necessary to give rise to Well Fargo’s requirement to make payment has occurred by the end of Year 1.

2. The amount can be determined with reasonable accuracy, and

3. Economic performance has occurred.

Wells Fargo, quite naturally, took the position that all three prongs of the all-events test were met. The fact of the liability was fixed at the end of Year 1, it argued, because the amount due could not be refunded in Year 2, regardless of whether or not Wells Fargo conducted business within California. Furthermore, the amount of the liability could be determined with reasonable accuracy, as the liability was based on Year 1, rather than Year 2 income. And finally, economic performance had occurred, because under Regulation Section § 1.461-4(g)(6), economic performance occurs with respect to a liability for taxes as it is paid, which Wells Fargo did during Year 1 in the form of estimated payments.

Unfortunately for Wells Fargo, their deduction was not to be. And why not? Because of an arcane remnant left over the in the statute at I.R.C. § 461(d). Section 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.

That’s a bit confusing, so allow me to clarify: this rule provides that if a state changes its tax laws after 1960 — and, as a result of that change, the accrual date of the payment of state taxes is moved up to an earlier year — then the change in the state tax laws is ignored for purposes of federal tax law. In other words, it is the state law that was in place in 1960 that governs the timing of a deduction for federal income tax purposes. If that state law is changed post-1960 to a allow for a more favorable, accelerated deduction, the change is ignored. As the District Court explained in reaching its decision, “Time stands still in this tiny corner of the federal tax world.”

Now, that provision on its own wouldn’t be problematic. But as indicated above, the general rule that the tax paid by California corporations such as Wells Fargo in Year 1 for the right to do business in Year 2 was not refundable didn’t come to be until 1972. Prior to 1972, if a business pulled out of California in Year 2, it could be refunded the tax paid in Year 1, either in part or in full.

In other words: Before 1972 = California state law said the Year 1 tax could be refunded.

                                After 1972 = California state law said the Year 1 tax could not be refunded.

And for some reason no one can explain, the Internal Revenue Code continues to provide that when determining whether a liability to pay California taxes is fixed at the end of Year 1, it is the state law in effect in 1960 that governs, despite the rather relevant fact that we currently reside in the year 2012.

Faced with these facts and the language in I.R.C. § 461(h), the District Court had no choice but to hold that the all-events test had not been met at the end of Year 1. Because under the state law in place in 1960, if Wells Fargo left California  on Day 1 of Year 2 it would receive a refund of the entire liability, the Year 2 liability was not fixed at the end of Year 1. The fact that a new law had been in place for 40 years providing that the Year 1 tax was not refundable was irrelevant.

The lesson? Cut us tax people some slack. When you ask us a question and we don’t feel comfortable giving an off-the-cuff answer, it’s not an indication that we’re not knowledgeable. Rather, our trepidation is the the result of being burned enough by outdated or inexplicable sections of the Code and regulations to know that we’d better check things out before we commit to a response.

*second thing may not have happened.

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