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Deducting State Taxes: A Complicated Affair
In what taxable period is an accrual-basis taxpayer allowed a deduction on its federal tax return for state franchise taxes? Compared to other complex tax issues, this question should be easy to answer, however Taxand USA showcases a case study where this wasn't so clear cut.
The Wells Fargo Case
Up until 2003, Wells Fargo regularly took a deduction for the taxes that it paid in Year 1 for the privilege of conducting business in California in Year 2 on the federal tax returns that it filed for Year 2. Wells Fargo filed an election to change its method of accounting for deducting these taxes effective for its 2003 tax year contending that, as an accrual-method taxpayer, it ought to be able to take a deduction for the California taxes on the federal tax returns that it files for Year 1. Both Wells Fargo and the government agreed that if Wells Fargo's tax treatment depended on California law as it has existed since 1972, then this would be okay. However the introduction of section 461(d) renders the 1972 change in California law irrelevant, making California law as it existed before 1961 as what counts. The Court decided that Wells Fargo could not take a deduction for California taxes until Year 2.
As evidenced by various decisions and rulings in this area, it is critical for all companies operating in the US that before taking a deduction for state taxes on their federal tax return, they should be aware of the interplay between Section 461(d) and the plethora of state and local tax laws that could result in its application. The popular view is that the precedent Wells Fargo was attempting to challenge will live on, and therefore this is something to watch out for.