Charles Schwab Corp. v. Commissioner

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
THE CHARLES SCHWAB 
CORPORATION AND INCLUDABLE
SUBSIDIARIES, No. 05-72899
Petitioner-Appellant,
v.  Tax Ct. No.
18095-98
COMMISSIONER OF INTERNAL
REVENUE,
Respondent-Appellee.

THE CHARLES SCHWAB 
CORPORATION AND INCLUDABLE
SUBSIDIARIES, No. 05-72902
Petitioner-Appellant,
v.  Tax Ct. No.
16903-98
COMMISSIONER OF INTERNAL OPINION
REVENUE,
Respondent-Appellee.

Appeal from a Decision of the
United States Tax Court
Argued and Submitted
April 18, 2007—San Francisco, California
Filed August 2, 2007
Before: Mary M. Schroeder, Chief Circuit Judge,
Stephen S. Trott and William A. Fletcher, Circuit Judges.
Per Curiam Opinion
9273
CHARLES SCHWAB CORP. v. CIR 9275
COUNSEL
Glenn A. Smith, Palo Alto, California, attorney for the
petitioner-appellant.
Bridget M. Rowan, Department of Justice, Washington, D.C.,
for the respondent-appellee.
9276 CHARLES SCHWAB CORP. v. CIR
OPINION
PER CURIAM:
This dispute concerns when the taxpayer may deduct on its
federal return payment of its California state franchise tax.
The appellant taxpayer is the Charles Schwab Corporation
and its subsidiaries, Schwab Holdings, Inc. and Charles Sch-
wab & Co., Inc. (referred to collectively as “Schwab”). Sch-
wab’s California income has grown greatly since it began
doing business in the state in April 1987. It would like to
deduct its franchise tax payments earlier than the Tax Court
ruled it could.
Schwab uses the accrual method of accounting and thus
may deduct expenses on its federal tax return for the year in
which they accrue. See I.R.C. § 461(a). Pursuant to California
law in effect at all times material to this litigation, Schwab’s
state franchise tax liability accrued on the last day of the year
in which Schwab earned the income forming the basis for the
tax assessment (December 31 of the “income” or “measuring”
year). See Epoch Food Serv., Inc. v. Comm’r, 72 T.C. 1051,
1054 (1979). Federal law, however, provides that a taxpayer’s
accrual date for federal tax purposes may be no earlier than
it would have been under state law as it existed at the end of
1960. See I.R.C. § 461(d)(1). Under pre-1961 California law,
the franchise tax did not accrue until the first day of the year
following the income year (January 1 of the “taxable” year).
See Cent. Inv. Corp. v. Comm’r, 9 T.C. 128 (1947), aff’d 167
F.2d 1000 (9th Cir. 1948). We therefore affirm.
Background and Analysis
Most businesses operating in California, including Schwab,
are required to pay a yearly franchise tax the state levies “for
the privilege of exercising its corporate franchise[ ]” within
the state. Cal. Rev. & Tax. Code § 23151(a); see also Cent.
Inv. Corp., 9 T.C. 131. During the years at issue in this
CHARLES SCHWAB CORP. v. CIR 9277
appeal, California calculated a corporation’s franchise tax lia-
bility based upon the corporation’s income from the preceding
year — the so-called “income” year. Cal. Rev. & Tax. Code
§ 23151.1(a); Charles Schwab Corp. v. Comm’r, 122 T.C.
191, 203 (2004) (“Schwab II”). Hence, the more money the
business earns in a given year, the higher its tax liability in the
following year.
Schwab provides discount securities brokerage and related
services throughout the United States. It began doing business
in California on April 1, 1987, and has been very successful,
increasing its California income each year. From the inception
of its business in California, Schwab reported its California
state taxes, including the franchise tax, on a calendar year
basis. For all but the first year of its operations it reported its
federal taxes on a calendar year basis, as well. Schwab
changed its federal reporting period to a calendar year begin-
ning April 1, 1988. As a result, it had two federal reporting
periods in 1988: March 31, 1987 to March 31, 1988, and
April 1 to December 31, 1988.
In a previous case, the Tax Court held that Schwab’s fran-
chise tax liability based on its 1988 income accrued on
December 31, 1988, rather than on January 1, 1989, and
therefore could be deducted on Schwab’s 1988 federal return.
See Charles Schwab Corp. v. Comm’r, 107 T.C. 282, 301
(1996) (“Schwab I”). The court explained that California’s
franchise tax regime imposed special rules on corporations
during their first two years of operation. Those rules, which
caused a corporation’s franchise tax liability to accrue on
December 31 of the income year, had been in place since
before 1961. As a result, the court concluded that I.R.C.
§ 461(d)(1) was inapplicable because there had been no accel-
eration of Schwab’s accrual date. Id. at 298-300. In this
appeal, Schwab contends that a December 31 accrual date
should continue to apply for 1989 through 1992. The Com-
missioner responds that, for years at issue here, I.R.C.
9278 CHARLES SCHWAB CORP. v. CIR
§ 461(d)(1) requires that Schwab’s franchise tax liability not
accrue until the following January 1.
[1] Section 461(d)(1) of the Internal Revenue Code “was
enacted in 1960, to proscribe the acceleration of state and
local tax deductions due to state or local legislation enacted
after 1960.” Schwab II, 122 T.C. 199. The section nullifies
state efforts to move up the accrual date of the franchise tax.
It provides:
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, . . . such
taxes shall be treated as accruing at the time they
would have accrued but for such action by such tax-
ing jurisdiction.
I.R.C. § 461(d)(1).
California amended its franchise tax in 1972. Under pre-
1972 law, a corporation that stopped doing business did not
pay any franchise tax on the income earned during its final
year of operation. See Cal. Rev. & Tax. Code § 23332 (1960).
By contrast, under post-1972 law, such a corporation would
be taxed on “its net income for the taxable year during which
the corporation ceased doing business.” See Cal. Rev. & Tax.
Code § 23151.1(d). The purpose of this change was to crack
down on corporations that avoided their franchise tax obliga-
tions by dissolving immediately after engaging in a profitable
transaction.
[2] One effect of the 1972 changes was to shift the time
when the franchise tax accrued, at least for corporations that
had been in business for two years or more. Before 1972, the
franchise tax obligation of such corporations did not accrue
until the first day of the taxable year. The reason is that, even
though the tax was calculated based on the income of the pre-
ceding year (the income year), “all of the events . . . that
CHARLES SCHWAB CORP. v. CIR 9279
establish the fact of liability” did not occur until the corpora-
tion did business during the taxable year. Treas. Reg. 1.461-
1(a)(2) (discussing when an accrual taxpayer incurs liability).
If the corporation ceased to operate before the start of the tax-
able year, it would owe no tax on the prior year’s income. The
Tax Court, in a decision affirmed by our Circuit, expressly
adopted this interpretation of California franchise tax accruals
under pre-1972 law. See Cent. Inv. Corp., 9 T.C. 133
(“[W]e are unable to see how any liability can arise for a tax
imposed on the privilege of doing business for a year not yet
commenced . . . . If no business operations were carried on in
the taxable year the tax would not be imposed.”).
[3] After 1972, a corporation could no longer avoid paying
the franchise tax on income earned during its final year of
operation. Consequently, all events necessary to establish lia-
bility occurred prior to the start of the taxable year, and the
tax accrued on December 31 of the income year. As the Tax
Court recognized, “[T]he effect of the 1972 California amend-
ment pertaining to dissolving corporations was to change the
accrual date for the taxable year’s tax based on the preceding
year’s net income from January 1 of the taxable year to
December 31 of the preceding year.” Epoch Food Serv., 72
T.C. 1054. We agree with the Tax Court that “such an
advancement of the accrual date is squarely controlled by sec-
tion 461(d)(1) which operates as a limitation on the taxpayer’s
right to otherwise accrue and deduct a tax.” Id.
In earlier litigation between Schwab and the Commissioner,
the Tax Court allowed Schwab to accrue and deduct its 1987
and 1988 franchise tax obligations in the income rather than
the taxable years, because Schwab’s first year was a “short”
year, i.e., less than twelve months. Where a business’ first
year is a short year, special California rules apply to the
accrual dates of its first and second years’ franchise taxes. See
Schwab I, 107 T.C. 298; Cal. Rev. & Tax. Code § 23222.
Accordingly, in Schwab I, the Tax Court held that § 461(d)(1)
9280 CHARLES SCHWAB CORP. v. CIR
did not apply to the accrual dates of Schwab’s first two years
of franchise tax payments. Id. at 300-01.
On March 31, 1988, when Schwab changed its federal
reporting period from a fiscal to a calendar year, it created a
“short” federal reporting period beginning on April 1, 1988.
See Schwab II, 122 T.C. 205. This change, combined with
the fact that Schwab could no longer claim the benefit of Cali-
fornia’s special rules, created what the Tax Court termed an
“anomalous” result: Schwab could not take any federal deduc-
tion on its 1989 return. Id. Because Schwab had deducted its
1988 franchise tax liability on its 1988 federal return, and
because § 461(d)(1) applied to Schwab’s liability beginning in
1989, the Tax Court in Schwab II found that Schwab’s next
available deduction would accrue on January 1, 1990, repre-
senting its 1989 franchise tax obligation. Id.
The Commissioner, however, moved for reconsideration of
Schwab II. The Commissioner conceded that Schwab should
be allowed to deduct on its 1989 federal tax return the state
franchise tax payment based upon its 1988 income. Charles
Schwab Corp. V. Comm’r, 123 T.C. 307 (“Schwab III”).
The Tax Court accepted the Commissioner’s concession,
despite the fact that Schwab already had been permitted a
deduction for its state franchise tax payment, based upon its
1988 income, on its 1988 federal return. The Tax Court
explained that, under pre-1972 law, Schwab’s franchise tax
obligation for both its second and third years of operation was
based upon its second year income. Id. at 310-11.
[4] The critical Tax Court holding for purposes of this
appeal is that, because of § 461(d)(1), Schwab must deduct on
its 1989 federal return its franchise tax liability based upon its
1988 income rather than its 1989 income. The Tax Court’s
holding in Schwab I that § 461(d)(1) did not affect Schwab’s
franchise tax accruals and deductions in 1987 and 1988 rested
on special rules that applied only during Schwab’s first two
years of operation. The Tax Court properly concluded that,
CHARLES SCHWAB CORP. v. CIR 9281
for the years at issue here, § 461(d)(1) required Schwab to
determine the timing of its franchise tax accruals pursuant to
pre-1961 law. As a result, Schwab’s liability accrued on Janu-
ary 1 of the taxable year rather than December 31 of the pre-
ceding income year, meaning Schwab was entitled to deduct
on its 1989-1992 federal tax returns its franchise tax obliga-
tions based upon its 1988-1991 income.
[5] The Tax Court early on held that the 1972 change to
California franchise tax law triggered application of
§ 461(d)(1). Epoch Food Serv., 72 T.C. 1054. That holding
rested on the Tax Court’s earlier holding in Central Invest-
ment Corp., which this court affirmed. See 9 T.C. 133
(under the pre-1961 version of California law, franchise tax
liability accrued on the first day of the taxable year). Schwab
contends that the Commissioner’s concession regarding its
1989 deduction negates the applicability of § 461(d)(1) for
later years. This position is not tenable. The Commissioner’s
concession was related to Schwab’s change to reporting on a
calendar year basis beginning April 1, 1988. It was limited to
that year. Nothing in the Tax Court decision alters the fact
that § 461(d)(1) applies to Schwab’s deductions after that
change, when Schwab could no longer claim the benefit of
special rules applicable to short business and reporting years.
The Tax Court correctly applied its own precedent and
§ 461(d)(1) in determining that Schwab’s franchise tax liabil-
ity for the second half of 1988 and all subsequent years
accrued January 1 of the taxable year, and not December 31
of the income year.
The judgment of the Tax Court is AFFIRMED.