The Charles Schwab Corporation and Subsidiaries v. Commissioner

122 T.C. No. 10

• Court: United States Tax Court
• Decided: March 9, 2004
• Docket: 16903-98, 18095-98
• Status: Unknown

Opinion

122 T.C. No. 10

UNITED STATES TAX COURT

THE CHARLES SCHWAB CORPORATION AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 16903-98, 18095-98. Filed March 9, 2004.

P, for Federal tax reporting purposes, claimed a California franchise tax deduction for 1989. Subsequently, P claimed the 1989 deduction for an earlier year and was successful in that claim in prior litigation before this Court. For purposes of these cases, P claims entitlement to franchise tax deductions for 1989 in the amount originally deducted for 1990. In like manner, P claims the franchise tax deductions originally claimed for 1993, 1992, and 1991 are now deductible for the preceding years of 1992, 1991, and 1990, respectively. R contends that sec. 461(d), I.R.C., proscribes such deductions because they are based on 1972 California legislation that provided for the acceleration of the accrual date for said taxes. P contends that sec. 461(d), I.R.C., does not proscribe its franchise tax deductions so long as California’s 1972 legislation does not result in a double franchise tax deduction for 1989 and/or later years. - 2 -

P, a discount stock brokerage, purchased all of the stock of a smaller discount stock brokerage and elected to allocate the purchase price amongst the assets of the acquired brokerage. P valued the customer accounts acquired in the stock purchase and amortized them. R contends that P’s acquired discount brokerage customer accounts are not amortizable because of differences from the customers/subscribers for which the Supreme Court permitted amortization in Newark Morning Ledger Co. v. United States, 507 U.S. 546, 566 (1993). R further contends that P has overvalued the customer accounts and that, in some instances, the useful lives of the accounts may not be determinable.

Held: Sec. 461(d), I.R.C., interpreted--P is not entitled to accelerate California franchise tax deductions for the years under consideration.

Held, further, P’s discount brokerage customer accounts may be amortized and are not necessarily distinguishable from the subscriber accounts considered in Newark Morning Ledger Co.

Held, further, P has shown the value and useful life of the acquired customer accounts and is entitled to amortize them.

Glenn A. Smith, Erin M. Collins, Laurence J. Bardoff, and

Patricia J. Galvin, for petitioner.

Rebecca T. Hill, for respondent.

GERBER, Judge: Respondent, in these consolidated cases,1

determined deficiencies in petitioner’s2 1989, 1990, 1991, and

1 These cases have been consolidated for purposes of trial, briefing, and opinion. Docket No. 16903-98 pertains to petitioner’s 1989, 1990, and 1991 tax years, and docket No. 18095-98 pertains to petitioner’s 1992 tax year. 2 The use of “petitioner” relates to the three entities that make up the consolidated group. - 3 -

1992 income taxes of $2,245,332, $2,797,349, $3,101,526, and

$827,683, respectively. By means of amended answers, respondent

asserts increased income tax deficiencies of $2,644,782,

$2,906,015, $3,210,191, and $936,349 for petitioner’s tax years

1989, 1990, 1991, and 1992, respectively.3 The issues presented

for our consideration are: (1) Whether section 461(d)4

proscribes certain California franchise tax deductions petitioner

claims; (2) whether petitioner’s acquired discount stock

brokerage customer accounts may be amortized; (3) if the customer

accounts may be amortized, whether petitioner has established

their fair market value; (4) whether petitioner has shown the

“useful lives” of certain customer accounts for purposes of

amortization; and (5) alternatively, if petitioner is

unsuccessful regarding issues (2), (3), and (4), whether

3 In the amended answers, respondent asserted increased deficiencies attributable to the franchise tax issue and the amortization of intangibles. For 1989, respondent made no determination with respect to the franchise tax deduction petitioner claimed. After the notice of deficiency was issued, petitioner was successful in claiming the amount originally claimed in 1989 in its short year ended Dec. 31, 1988. Accordingly, respondent asserts an increased deficiency to account for petitioner’s change in position. As to the amortization of intangibles, respondent originally determined that petitioner was entitled to some amortization. Respondent changed his position in the amended answer, denying petitioner any amortization and asserting increased deficiencies. 4 Section references are to the Internal Revenue Code in effect for the periods under consideration. Rule references are to the Tax Court Rules of Practice and Procedure. - 4 -

petitioner is entitled to an abandonment loss equal to the value

of the acquired intangibles it abandoned after the business

acquisition.

FINDINGS OF FACT5

Petitioner comprises three corporations that file

consolidated Federal corporate income tax returns. The group

consists of the Charles Schwab Corp., a Delaware corporation, its

first-tier subsidiary, Schwab Holdings, Inc., a Delaware

corporation, and its second-tier operating subsidiary, Charles

Schwab & Co., Inc., a California corporation. At the time of the

filing of the petitions in these consolidated cases, petitioner’s

principal office was in San Francisco, California.

Petitioner provides discount securities brokerage and

related financial services, primarily to individuals, throughout

the United States and is a member of all major U.S. securities

exchanges. During the years under consideration, the principal

service petitioner provided was to execute trade orders to

facilitate sales and purchases of stock and securities on behalf

of customers. Petitioner’s business strategy was to serve self-

directed customers who either did not require research,

investment advice, or portfolio management or did not desire to

5 The parties’ stipulations of fact are incorporated by this reference. Over the period from March 2000 through October 2002, the parties entered into six stipulations of fact with exhibits, all of which have been received into evidence. - 5 -

pay higher commissions to cover the costs of those services. For

Federal income tax purposes, petitioner reports income and

deductions under the accrual method of accounting and has adopted

the “recurring item exception” under section 461(h)(3).

On February 9, 1987, petitioner qualified to do business in

California and on April 1, 1987, began operations. Petitioner

used a calendar year for California franchise tax purposes.

Petitioner’s first tax year for Federal income tax purposes ended

on March 31, 1988. In its second and successive years,

petitioner’s tax year for Federal income tax purposes was changed

to the calendar year.

Petitioner’s California franchise tax liabilities were

originally deducted on its Federal corporate income tax returns

in the following manner:

California California Income Franchise Computational Tax Base Federal Tax Year Tax Liability

1987 calendar year FYE 3/31/88 $879,500 1988 calendar year 1989 calendar year 932,979 1989 calendar year 1990 calendar year 1,806,588 1990 calendar year 1991 calendar year 2,066,547 1991 calendar year 1992 calendar year 3,778,547 1992 calendar year 1993 calendar year 5,578,718

Petitioner, on its Federal corporate income tax return for the

short (9-month) year ended December 31, 1988, did not claim a

California franchise tax deduction. - 6 -

In Charles Schwab Corp. & Includable Subs. v. Commissioner,

107 T.C. 282 (1996) (Schwab I), affd. on another issue 161 F.3d

1231 (9th Cir. 1998), cert. denied 528 U.S. 822 (1999),

petitioner claimed that the $932,979 originally deducted on its

1989 calendar year return was deductible for its short year ended

December 31, 1988. This Court held that petitioner was entitled

to deduct the $932,979 for its short year ended December 31,

1988. Id. That holding left petitioner unable to deduct the

$932,979 for its calendar year 1989, as it had on its original

1989 corporate return. For purposes of this Federal tax

litigation, petitioner now claims to be entitled to deduct

California franchise tax liabilities for the same taxable period

for which the franchise tax was calculated; i.e., the year prior

to the year for which petitioner originally deducted the

California franchise tax on its Federal tax returns. The

following schedule reflects the years and amounts for which

petitioner originally claimed California franchise tax

deductions, and the years and amounts for which petitioner claims

deductions for purposes of this litigation:

Amounts Taxable Year Originally Claimed Now Claimed

1989 $932,979 $1,806,588 1990 1,806,588 2,066,547 1991 2,066,547 3,778,547 1992 3,778,547 5,578,718 1993 5,578,718 N/A - 7 -

By mid-1988, petitioner’s long-term plan included the

strategic objective of increasing its market share by various

means, including the acquisition of other discount brokerages.

On March 31, 1989, petitioner purchased all of the shares of

stock in Rose & Co. Investment Brokers, Inc. (Rose), from Chase

Manhattan Corp. (Chase). Petitioner paid $34,122,661 cash at a

time when Rose’s liabilities totaled $146,279,570. In addition,

petitioner’s capitalized acquisition fees for the acquisition of

the Rose stock were $974,638. Accordingly, petitioner’s

“Modified Aggregate Deemed Sales Price” (MADSP), as defined in

section 1.338(h)(10)-1T(f), Temporary Income Tax Regs., 51 Fed.

Reg. 745 (Jan. 8, 1986) (in effect for 1989), was $181,376,869

($34,122,661 + $146,279,570 + $974,638 = $181,376,869).

Petitioner also paid $3 million for an agreement not to compete

from Chase.

Christopher V. Dodds was a key employee of petitioner who

was responsible for evaluation and implementation of corporate

acquisitions and investment opportunities. Mr. Dodds was

individually responsible for the quantitative and qualitative

evaluation that was used as the basis for petitioner’s

acquisition of Rose. Mr. Dodds prepared a report, “Project

Colors”, which he presented to petitioner’s board of directors.

In addition to preparing the report, Mr. Dodds was one of the two - 8 -

individuals who represented petitioner’s interests in the

negotiations with Chase in the course of petitioner’s acquisition

of Rose.

Although petitioner’s primary interest and goal was to

purchase the Rose customer accounts, Chase was willing to sell

the customer accounts only along with the rest of Rose’s assets.

At the time of the acquisition, petitioner was the predominant

discount broker in the financial services industry with a 42.4-

percent market share on the basis of total commissions for the

period January through September 1988. The next largest discount

broker was Fidelity with a 17.8-percent market share. Rose was

the fifth largest discount broker with a 2.8-percent market

share.

The Rose customers were generally equity and option traders

with characteristics very similar to those of petitioner’s

customers. Rose used five categories to classify its customers:

Cash, cash management, margin, pension, and institutional.

Petitioner used only three categories of customer classification:

Cash, margin, and pension. Petitioner did not generally have

institutional customers. Rose’s institutional customers

represented a relatively small portion of Rose’s customer base,

in both actual numbers and the amount of revenue generated.6

6 For purposes of these cases and because Rose’s institutional customers were not significant in number, it (continued...) - 9 -

Petitioner maintained offices in all but one of the markets where

Rose’s customers were located. Petitioner, to some extent,

provided more services to its customers than did Rose.

Corresponding to the level of services, the fees charged to

Rose’s customers were 8-13 percent less than those charged to

petitioner’s customers. Generally, Rose’s customers were more

active traders than petitioner’s customers. There were some

additional, but less significant, differences in the customer

bases, and petitioner believed that it generally offered more to

its customers than Rose offered to its customers. Petitioner’s

analysis focused on the value of Rose’s customer accounts and the

income that could be derived from them. On the basis of the

analysis performed by Mr. Dodds and others, petitioner concluded

that customers acquired from Rose would likely assimilate and be

retained as customers of petitioner.

During June 1990, Deloitte & Touche (Deloitte) submitted an

appraisal of the fair market values of the Rose assets to

petitioner. Petitioner used the Deloitte appraisal to allocate

its MADSP to the Rose assets. On the basis of the Deloitte

6 (...continued) appears that each party has merged the Rose’s institutional customers into another category. Essentially, the parties’ positions are based on three major categories of customer accounts for petitioner and four major categories for respondent. - 10 -

appraisal, petitioner allocated approximately $12,587,000 to the

Rose customer accounts it acquired through the stock purchase

Deloitte’s $12,587,000 value for the Rose accounts for

section 338 tax basis purposes comprised the following:

Customer Accounts Amount

Cash brokerage $4,014 Margin brokerage 6,522 Pension 2,051

Total customer accounts 12,587

In valuing the Rose accounts, Deloitte compared Rose’s customer

account categories with those of petitioner and determined, with

one exception, that both companies used similar categories to

differentiate their customers. In addition to cash, margin, and

pension accounts, Rose also had a category for “Institutional”

customers.

Deloitte’s first step was to analyze Rose’s annual (12-

month) income for each of the four types of accounts for the

period ended March 31, 1989. Next, the useful lives of the

accounts were determined on the basis of petitioner’s actual

experience. Petitioner’s data was used because Rose’s data was

not available and it was expected that petitioner’s data would be

more accurate since the Rose customers were to be part of

petitioner’s business environment. - 11 -

With respect to the cash and margin accounts, Deloitte

performed an actuarial study of petitioner’s comparable account

activity. Deloitte developed a survival curve reflecting the

rate of retirement and the age of the assets. The start and

termination dates for each account in existence from 1975 to 1989

were reviewed. On the basis of that analysis, it was determined

that cash and margin customer accounts had useful lives of 4 and

6 years, respectively.

Rose’s total revenues from cash and margin accounts were

determined to be $6,183,294 and $6,765,276, respectively.

Adjustments were then made to account for petitioner’s revenue

growth in the form of a 12-percent increase over each 4-year

period. Thereafter pretax earnings were derived by applying the

pretax profit margins petitioner used in its evaluation of the

Rose business entity. A 34-percent Federal tax rate was applied

to derive an after-tax income stream. Then the present value of

the income stream was determined by applying a 16-percent

discount. Using that methodology, the fair market values of

Rose’s cash and margin customer accounts were determined to be

$4,130,000 and $6,711,000, respectively.

Using the same methodology as used for the cash and margin

accounts, Deloitte determined that the useful life of the pension

customer accounts was 14.66 years (rounded to 15) with a fair

market value of $2,110,000. The total fair market value of the - 12 -

acquired Rose customer accounts was $12,951,000, which was

adjusted to $12,587,000 as an allocation of tax basis under

section 338.

Deloitte allocated the value of Rose’s institutional

customers, which represented a small portion of Rose’s total

customers (in actual numbers and revenue), between the intangible

assets denominated “Chase Vendor Agreements” and “Chase Priority

Marketing Access Agreement”. The vendor and marketing agreements

were valued at $592,000 and $690,000, respectively, and were

assigned a tax basis of $575,000 and $671,000, respectively.

On April 30, 1989, Rose was merged into petitioner, and by

June 30, 1989, petitioner had withdrawn Rose’s trade name from

use. By that same time, petitioner had closed all Rose’s offices

and sold Rose’s furniture and fixtures. Approximately 25 of the

107 Rose employees continued their employment with petitioner,

and the others either refused offers or were terminated after the

acquisition. Former Rose brokers who stayed on with petitioner

were required to service any retained Rose customers under

petitioner’s service policies. For example, it was Rose’s policy

to have a specific broker service a particular customer, whereas

under petitioner’s approach, customer representatives did not

typically have specific customers.

In determining the price to offer or pay for Rose,

petitioner used comparable sales and discounted cashflow - 13 -

methodologies. Ultimately, however, the focus was on the worth

of Rose’s revenue stream and cashflow. In determining

petitioner’s operating costs to be attributed to the revenues

generated by the acquired Rose accounts, petitioner used a

methodology which was denominated the “five years to fully

loaded” approach. Under that approach, revenues from the newly

acquired Rose accounts were not considered to bear the cost of

any of petitioner’s operating expenses for the period immediately

following acquisition and then to increasingly bear petitioner’s

operating costs to a level of parity after 5 years (when the Rose

accounts become “fully loaded”). At the time of the Rose

acquisition, petitioner’s “fully loaded” profit margin was 21

percent, which included consideration of petitioner’s

depreciation of fixed assets.

Mr. Dodds determined that there were both positive and

negative synergies in connection with the acquisition of Rose.

The positive synergy was considered the account base or revenue

stream that could be coupled with petitioner’s excess capacity to

service customers in its brokerage business. Petitioner expected

to strengthen its market presence in its role as the largest

discount broker and to increase its geographical marketplace

activity in Chicago and New York. Because petitioner had excess

customer capacity, it did not have to acquire Rose’s

infrastructure. Accordingly, the negative synergy consisted of - 14 -

the cost of severing Rose employees and terminating leases, and

closing down and liquidating unneeded Rose infrastructure. On

the basis of internal judgment and experience, petitioner

determined that 5 years was a suitable period for the Rose

customers to be absorbed into petitioner and to bear the overhead

burdens in parity with petitioner’s existing accounts at the time

of acquisition.

OPINION

I. California Franchise Tax

This issue arises in connection with the parties’

disagreement concerning the application and interpretation of

section 461(d) and section 1.461-1(d)(1), Income Tax Regs.

Section 461(d) was enacted to proscribe the acceleration of State

and local tax deductions due to State or local legislation

enacted after 1960. Ultimately, this is a matter of timing and a

question of for which year(s) petitioner is entitled to deduct

California franchise tax.

Petitioner’s position is that section 461(d) was enacted to

prevent situations where taxpayers might receive two franchise

tax deductions in the same taxable year. The post-1960

California legislation in question does not, in petitioner’s

factual circumstances, cause more than one deduction in any year

under consideration. Conversely, respondent’s position is that - 15 -

section 461(d) is not so limited in its application and that it

proscribes any acceleration of the accrual of State tax produced

by post-1960 legislation.

Under respondent’s interpretation, petitioner would not be

entitled to a franchise tax deduction for its 1989 calendar

year.7 Respondent contends that the fact that petitioner does

not receive a 1989 franchise tax deduction is due to unique

factual circumstances surrounding petitioner’s 1989 reporting

year. Conversely, petitioner’s interpretation of section 461(d),

if correct, would result in franchise tax deductions greater than

those originally claimed, including those for petitioner’s 1989

tax return.

Section 164(a) generally provides for the deduction of

qualified State and local taxes in the year paid or accrued. The

California franchise tax is a type of tax that would normally be

deductible under section 164(a). The application of section 164

was modified during 1960 by the enactment of section 461(d),

7 Petitioner’s original reporting position for 1989 was to claim a $932,979 deduction for California franchise tax and no deduction for its short taxable year ended Dec. 31, 1988. In Charles Schwab Corp. & Includable Subs. v. Commissioner, 107 T.C. 282 (1996) (Schwab I), affd. on another issue 161 F.3d 1231 (9th Cir. 1998), cert. denied 528 U.S. 822 (1999), it was decided that petitioner was entitled to deduct the $932,979 in its short taxable year ended Dec. 31, 1988, leaving the 1989 year with no deduction for California franchise tax. Petitioner then claimed that $1,806,588, originally deducted for 1990, should be deductible for 1989. In turn, respondent amended the answer in response to petitioner’s change from its reporting position. - 16 -

which proscribes the accrual of State tax attributable to post-

1960 State legislation that would accelerate the accrual of such

tax. Section 461(d)(1) 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.

Petitioner contends that section 461(d) was intended to

prevent a taxpayer from deducting two State tax liabilities in

any 1 Federal taxable year. Going a step further, petitioner

contends that it is entitled to an accelerated deduction for

State tax, so long as it does not become entitled to more than

one California franchise tax deduction for any Federal taxable

reporting year. Petitioner’s position, in great part, appears to

be sourced in the following legislative history that provides

some of the bases for enactment of section 461(d):

it is to be noted that the rule of law that a tax liability is accruable on a certain date such as the assessment or lien date has developed over a long period of years through court decisions and is a basic concept which the Internal Revenue Service has recognized in numerous rulings. Several States in recent years have changed this accrual date from January 1 to [the preceding] December 31 in order to provide an extra accrual date for State taxes. This amendment [adding sec. 461(d)], which would be effective for years after 1960 [the year of enactment] and thus put the States and taxpayers on proper notice, would change the law to provide for only one accrual - 17 -

for State taxes in any one taxable year where the State legislature has changed the accrual date, and would thus eliminate the additional deduction available under existing law. * * *

Conf. Rept. 2213, 86th Cong., 2d Sess. (1960), 1960-2 C.B. 902,

905.

The operation of section 461(d) is illustrated by section

1.461-1(d)(3), Example (1), Income Tax Regs. In that example,

the tax assessment (and therefore accrual) date was July 1 each

year, and in 1961 the State changed the law to move the

assessment date from July 1, 1962, to December 31, 1961. But for

section 461(d), taxpayers, under the accrual method of

accounting, would have been entitled to accrue and deduct, for

the Federal tax year 1962, the State tax assessed on both July 1,

1962 (for the 1961 State tax year), and December 31, 1962 (for

the 1962 State tax year), because of the change in the law.

To better understand the factual context in which this

controversy arises, we must consider the events that occurred

before petitioner’s 1989 tax year (the first taxable year we

consider). The 2 years immediately preceding 1989 were the

subject of a controversy before this Court and addressed in an

Opinion. See Charles Schwab Corp. & Includable Subs. v.

Commissioner, 107 T.C. 282 (1996). That case involved

petitioner’s first years of operation in California and its

initial experience with the California franchise tax. - 18 -

Petitioner commenced business in California during 1987 and

for its Federal tax year ended March 31, 1988, deducted $879,500

for California franchise tax paid on its 1987 California

franchise tax income. That deduction was based on a January 1,

1988, accrual date. Respondent did not question that deduction.

Instead, the controversy in Schwab I concerned whether petitioner

was entitled to a $932,979 franchise tax deduction for its short

(9-month) Federal tax year ended December 31, 1988.8

In that case, respondent argued that petitioner was not

entitled to the $932,979 franchise tax deduction for its short

1988 calendar year because the 1972 amendments in California law

(1972 amendments) resulted in a proscribed acceleration of the

accrual under section 461(d)(1). In particular, respondent

argued that the 1972 amendments, which changed the accrual date

from January 1 to the preceding December 31, caused the section

461(d)(1) proscription to apply. Under respondent’s argument

petitioner would not have been entitled to claim the $932,979

franchise tax deduction until its calendar year ended December

8 Petitioner, for purposes of reporting Federal tax, converted from a Mar. 31 fiscal year to a Dec. 31 calendar year during 1988 so that its calendar year ended Dec. 31, 1988, was a short year consisting of 9 months. Petitioner had not deducted the $932,979 on its Federal return for the short year ended Dec. 31, 1988. Instead, it had deducted that amount on its 1989 Federal return. In Schwab I, petitioner changed from its reporting position and claimed the $932,979 for the short Federal tax year ended Dec. 31, 1988, leaving the 1989 Federal year without a deduction for California franchise tax. - 19 -

31, 1989. The Court in Schwab I, however, held that the accrual

for petitioner’s short year ended December 31, 1988, was not

affected by the 1972 amendments. Charles Schwab Corp. &

Includable Subs. v. Commissioner, supra at 300.

In holding that petitioner was entitled to the $932,979

franchise tax deduction for its short year ended December 31,

1988, the Court in Schwab I reasoned that the California

franchise tax law, as it existed before the 1972 amendments,

would have permitted petitioner to accrue the $932,979 franchise

tax deduction as of December 31, 1988. Id. at 298-300.

Accordingly, the Court in Schwab I did not have to decide whether

section 461(d)(1) applied or whether it was triggered by

California’s 1972 amendments.

In these cases, we consider petitioner’s entitlement to

deductions of California franchise tax for 1989 and later years.

As in Schwab I, respondent contends here that the 1972 amendments

trigger the application of section 461(d)(1). Under respondent’s

position, petitioner would be limited to the accrual of franchise

tax on the January 1 date as provided for in the pre-1972

California franchise tax statute.9

9 Under respondent’s interpretation, petitioner would not be entitled to deduct the 1989 franchise tax until 1990, leaving a gap in the 1989 year due to the holding in Schwab I. - 20 -

Petitioner contends that it may use the December 31 accrual

date resulting in a deduction for its 1989 Federal tax year

because section 461(d)(1) was intended to address situations only

where a post-1960 change in State franchise tax law would result

in a double deduction in 1 tax year. Because petitioner was

permitted to deduct the 1988 short year California franchise tax

for its 1988 Federal tax year, the acceleration (caused by the

1972 amendments) of the 1989 franchise tax to petitioner’s 1989

Federal tax year does not result in two deductions in any one

taxable period. To understand why the 1972 amendments do not

result in more than one deduction in any of petitioner’s tax

years, we must review California’s franchise tax regime.

California’s first Bank and Corporation Franchise Tax Act

(promulgated in 1929) levied a tax “for the privilege of doing

business in the state during a given year, which year of

privilege is designated the ‘taxable year.’” Central Inv. Corp.

v. Commissioner, 9 T.C. 128, 131 (1947), affd. per curiam 167

F.2d 1000 (9th Cir. 1948); Filoli, Inc. v. Johnson, 51 P.2d 1093,

1094 (Cal. 1935); see also Cal. Rev. & Tax. Code sec. 23151(a)

(West 1992). Under the successor to that statute, the franchise

tax was payable for the “taxable year” as measured by the net

income earned by a corporate taxpayer during the preceding year,

which is referred to as the “income year”. Cal. Rev. & Tax. Code

secs. 23041(a), 23042(a) (West 1992). The only statutorily - 21 -

expressed exception to this approach concerns corporations with a

tax year beginning or ending during the taxable year.

Generally, and before the 1972 amendments, a corporation

beginning its first full taxable year in California paid

franchise tax based on the net income for the first taxable year.

In the next and successive years (second year and later) the

corporation’s franchise tax liability was based on the income

year (first or preceding year). Cal. Rev. & Tax. Code sec. 23222

(West 1992).

When a corporation’s first operational year is less than 12

months, California’s franchise tax treatment is different. The

difference occurs with respect to the second operational year.

For the first year the corporation is required to file a

franchise tax return within 2-1/2 months from the end of the

first short year. In effect, this tax is a prepayment of the tax

for the second year. For the second year, the corporation would

again file a return within 2-1/2 months from the end of the

second year and pay tax based on its second year’s net income.

Because of the prepayment based on the first short year, the

corporation is entitled to a credit against the second year’s

franchise tax liability. In that type of situation, beginning in

the third year, the franchise tax obligation would be based on

the income year (second year or first complete year in this

example) and so on. See id. sec. 23222(a). - 22 -

Before the 1972 amendment, California franchise tax for the

income year generally accrued on the first day of the taxable

year. Charles Schwab Corp. & Includable Subs. v. Commissioner,

107 T.C. at 297. Although the pre-1972 California franchise tax

was measured by the preceding year’s net income, it has been held

that it did not accrue until the taxable (or next) year. Central

Inv. Corp. v. Commissioner, supra at 132-133.

In Schwab I the Court explained that the 1972 amendments

were enacted to cause dissolving or withdrawing corporations to

be covered by the franchise tax.10 In effect, however, the 1972

amendments changed the accrual date for all California franchise

taxpayers from January 1 of the taxable year to December 31 of

the income year (preceding year).

The above-described rules addressing the franchise tax

liability for a corporation’s first year (but less than a full

year) of operation are the rules that this Court addressed in

Schwab I. Because petitioner’s second year11 franchise tax was

based on the second year’s net income under pre-1972 California

law, the assessment or accrual, in effect, occurred on December

10 The problem appears to be that a corporation that was dissolved or terminated before the Jan. 1 assessment date could avoid paying the franchise tax for its final year. To remedy this problem, the assessment date was moved back to Dec. 31 of the income year (measuring year). 11 The second year for California franchise tax purposes is petitioner’s first complete year of activity in California (1988). - 23 -

31, 1988. Charles Schwab Corp. & Includable Subs. v.

Commissioner, supra at 297; Epoch Food Serv., Inc. v.

Commissioner, 72 T.C. 1051, 1053 (1979). Accordingly, the Court

in Schwab I found that the 1988 California franchise tax was

assessed and accruable on December 31, 1988, on the basis of

California law before the 1972 amendments. Because of that

holding, there was no need for the Court to decide whether

section 461(d) and the underlying regulations proscribed any

acceleration caused by the 1972 amendments.12

Petitioner argues that section 461(d) was not intended to

result in circumstances in which a taxpayer is not entitled to

deduct any State tax in a particular year. More particularly,

petitioner contends that the sole intent for enactment of section

461(d) was to prohibit acceleration of the accrual attributable

to post-1960 State legislation that results in double deductions.

On the other hand, respondent argues that section 461(d) and the

regulations are unambiguous and a literal reading would result in

no accrual or deduction of California franchise tax in

petitioner’s 1989 year because it was deducted for petitioner’s

short year ended December 31, 1988, and no additional deduction

12 Because of this Court’s holding in Schwab I, petitioner received two California franchise tax deductions in connection with the 1988 calendar year: One for its year ended Mar. 31, 1988 (computed on the basis of the 1987 California “income year”), and one for its short year ended Dec. 31, 1988 (computed on the basis of the 1988 California “income year”). - 24 -

would have been available under the pre-1972 California franchise

tax regime. Respondent also points out that pre-1972 California

law, not the 1972 amendments, permitted petitioner a deduction

for its 1988 short Federal tax year. It was that chain of events

that caused a gap in petitioner’s annual accrual of California

franchise tax. We agree with respondent.

Section 461(d) explicitly addresses the type of legislation

enacted by California in the form of the 1972 amendments to its

franchise tax law. Epoch Food Serv., Inc v. Commissioner, supra

at 1054. The effect of the 1972 amendments was to accelerate the

accrual of franchise tax to an earlier tax year. If a

corporation was fully operational in California for years prior

to the 1972 amendments, but for section 461(d), that corporation

would have been entitled to two franchise tax accruals in the

first effective year of the 1972 amendments. Petitioner’s

idiosyncratic circumstances occurred because of the convergence

of its 1987 short year and the December 31, 1988, accrual of its

1988 short Federal tax year. Those unique circumstances do not

support different treatment for petitioner than would be afforded

to other California corporate franchise taxpayers for the taxable

years following petitioner’s unique initial circumstances for

1987-89. There is nothing in section 461(d) or the underlying - 25 -

legislative history that provides for such a result or otherwise

suggests that a taxpayer is guaranteed a tax accrual in every

taxable year.

One might be tempted to commiserate with petitioner about

what appears to be an anomalous result (i.e., no franchise tax

deduction is allowable for 1989). That result, however, is due

to the confluence and application of the California franchise tax

laws and section 461(d). From another perspective, however,

petitioner could be considered fortunate to have avoided the

proscription of section 461(d) with respect to its 1988 franchise

tax deduction as decided in Schwab I. It was that turn of events

that resulted in a break in the tax accounting pattern and caused

the result that no franchise tax deduction was available for

1989.

Section 461(d) may have been intended to avoid double

deductions of taxes due to post-1960 State legislation that

accelerated their accrual date. The articulated mechanism used

to effect that policy, however, prohibits a corporation from

“accruing taxes * * * earlier than it would [have] but for any

action of any taxing jurisdiction taken after December 31, 1960”.

That language unambiguously embraces the California franchise tax

for petitioner’s 1989 tax year (its second complete year) which

under pre-1972 California law would not accrue until January 1,

1990, and would be based on the 1989 “income year”. We find that - 26 -

the language of section 461(d) contains no ambiguity or anomaly,

and we therefore apply it according to its terms. United States

v. Ron Pair Enters, Inc., 489 U.S. 235, 241 (1989); Burke v.

Commissioner, 105 T.C. 41, 59 (1995). Accordingly, petitioner is

not entitled to the claimed California franchise tax deduction

for its 1989 tax year.

Petitioner claimed California franchise tax deductions for

the years under consideration on the basis of the pre-1972

California franchise tax rules (i.e., January 1 accrual for

franchise tax for the income year (year before the taxable

year)). On the basis of petitioner’s argument that section

461(d) did not apply because double deductions were not being

taken, petitioner sought increased franchise tax deductions from

those originally claimed on its returns. The increase results

from treating December 31 as the accrual date instead of the

succeeding January 1, which was the accrual date under the pre-

1972 California franchise tax statute. Because we have decided

that section 461(d) proscribes a taxpayer’s use of the 1972

amendments to accelerate the accrual of California franchise tax,

petitioner’s claim for increased franchise tax deductions must

fail for all years before the Court. - 27 -

II. Rose Issue

A. Background

Petitioner acquired the outstanding shares of the stock of

Rose, a discount stock brokerage, from Chase. An election was

made to treat the acquisition as one of assets and to apply the

rules under section 338 to assign the acquisition price to the

acquired assets. In the amended answer, respondent asserted that

petitioner may not amortize the customer accounts it acquired in

the Rose acquisition. If the customer accounts may be amortized,

we must also decide the values and useful lives of those

accounts.

The purchase of all of the outstanding shares of Rose’s

stock from Chase took place on March 31, 1989. Petitioner had no

interest in Rose’s business name or infrastructure. Rose was

financially troubled, and its liabilities were substantial in

relation to the value of its fixed assets. Rose’s liabilities

($146,279,570), in a relative sense, approached the amount of its

short-term assets ($165,472,000), which consisted mainly of

receivables.

Petitioner, a brokerage based on the West Coast, sought to

acquire Rose’s customer base in order to expand petitioner’s

presence in the Chicago and New York markets where Rose’s

operations were centered. Petitioner had existing capacity to

service more customers and sought to increase its own revenues by - 28 -

the acquisition of Rose’s customer base. Because Chase would not

sell Rose’s customer base separate from Rose’s other assets,

petitioner purchased Rose’s stock and discarded the Rose name and

infrastructure to gain access to Rose’s customer base. In line

with its goals, a short time after the acquisition, petitioner

employed a small number of Rose’s employees, abandoned the Rose

name, and jettisoned all infrastructure assets other than Rose’s

customer accounts, which petitioner then integrated into the

Schwab customer base.

Petitioner elected, under section 338(g) and (h)(10), to

treat the transaction as a purchase of Rose’s assets. Section

338 permits one corporation to acquire the stock of another

corporation and to elect to treat the transaction as a purchase

of the acquired corporation’s assets, with the benefit of a

stepped-up basis in the acquired assets.13 Under the regulations

in effect for 1989, the allocation of the stock purchase price to

the acquired assets involved the calculation of the MADSP, which

in this case was $181,376,869. See sec. 1.338(h)(10)-1T(f),

Temporary Income Tax Regs., 51 Fed. Reg. 745 (Jan. 8, 1986). The

MADSP is then allocated, in a statutorily prescribed order, to

certain defined categories of tangible assets. The allocation to

a particular asset may not exceed the fair market value of the

13 Sec. 338 was a codification of the holding in Kimbell- Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950), affd. per curiam 187 F.2d 718 (5th Cir. 1951). - 29 -

asset. Once the allocations have been made to the various

categories of tangible assets, the remainder of the MADSP, if

any, is then allocated to certain intangible assets, other than

goodwill. Finally, any remaining portion of the MADSP is

residually allocated to goodwill, a nonamortizable intangible

asset.

Just after the 1989 Rose acquisition, Deloitte prepared an

appraisal of the fair market values of the Rose assets. After

calculating the $181,376,869 MADSP and allocating amounts to the

tangible assets, Deloitte allocated a $12,587,000 value to the

Rose customer accounts petitioner acquired by purchase of Rose’s

stock from Chase. The $181,376,869 MADSP comprised petitioner’s

cash payment ($34,122,661), petitioner’s assumption of Rose’s

liabilities ($146,279,570), and petitioner’s acquisition costs

($974,638).

B. Are the Acquired Rose Discount Brokerage Customer Accounts Amortizable?

Section 167 provides for depreciation of property used in a

trade or business or held for the production of income. Section

1.167(a)-3, Income Tax Regs., interprets section 167 with respect

to the depreciation of intangible assets in the following manner:

If an intangible asset is known from experience or other factors to be of use in the business or in the production of income for only a limited period, the length of which can be estimated with reasonable accuracy, such an intangible asset may be the subject of a depreciation allowance. * * * No allowance will be - 30 -

permitted merely because, in the unsupported opinion of the taxpayer, the intangible asset has a limited useful life. No deduction for depreciation is allowable with respect to goodwill. * * *

As we explained in Fed. Home Loan Mortgage Corp. v.

Commissioner, 121 T.C. 254, 258-259 (2003):

For an intangible asset to be amortizable under section 167(a), the taxpayer must prove with reasonable accuracy that the asset is used in the trade or business or held for the production of income and has a value that wastes over an ascertainable period of time. Newark Morning Ledger Co. v. United States, 507 U.S. 546, 566 (1993); FMR Corp. v. Commissioner, 110 T.C. 402, 430 (1998). The taxpayer must prove that the intangible asset has a limited useful life, the duration of which can be ascertained with reasonable accuracy, and the asset has an ascertainable value separate and distinct from goodwill and going-concern value. S. Bancorporation, Inc. v. Commissioner, 847 F.2d 131, 136-137 (4th Cir. 1988), affg. T.C. Memo. 1986-601. * * *

Respondent admits on brief that customer accounts are one

type of intangible asset for which amortization may be available

under section 167. Respondent, however, focusing on the seminal

holding in Newark Morning Ledger Co. v. United States, 507 U.S.

546, 566 (1993) (Newark), argues that customer accounts of

brokers differ from newspaper subscriptions in ways which would

make the Newark holding inapplicable to the facts of these

cases.14 If the acquired customer accounts are found to be

amortizable, respondent argues in the alternative that petitioner

14 In Newark Morning Ledger Co. v. United States, 507 U.S. 546, 566 (1993) (Newark), the Supreme Court held that an acquired list of newspaper subscribers had a separate value and a limited useful life and was therefore amortizable. - 31 -

has not shown or established the values or the useful lives of

the Rose intangibles in question. Conversely, petitioner

contends that it has shown the separate values and useful lives

of the customer accounts and that respondent has misinterpreted

the holding in Newark.

In essence, respondent’s argument is that brokerage customer

accounts differ to such an extent that they do not fall within

the factual context of the Supreme Court’s holding in Newark.

Accordingly, we begin our analysis by considering the holding in

Newark. That case involved the question of whether an acquired

list of newspaper subscribers could be amortized. In connection

with a merger, the taxpayer allocated $67.8 million of the

acquisition cost to an intangible asset consisting of a list of

460,000 identified newspaper subscribers. Each of the

subscribers was described as being under an agreement for regular

delivery of the paper in return for payment of a periodic

subscription price. The $67.8 million allocation was based on

the taxpayer’s estimate of future profits to be derived from the

identified subscribers. - 32 -

In Newark,15 the Government’s principal argument was that

the intangible asset (list of paying subscribers) was

indistinguishable from goodwill and hence not amortizable. The

Supreme Court noted that the Government’s argument was based on

the premise that goodwill was not amortizable because it has “no

determinate useful life of specific duration.” Newark Morning

Ledger Co. v. United States, supra at 564-565. The Supreme Court

further noted that the Government’s justification for denying the

amortization of goodwill evaporates “when the taxpayer

demonstrates that the asset in question wastes over an

ascertainable period of time”, as it did in Newark. Id. at 565.

In holding that a customer list could be established as a

depreciable asset and thereby distinguished from goodwill, the

Supreme Court observed that the burden of doing so might be

substantial. Id. at 566-567. On the basis of the Supreme

Court’s observation, respondent contends that the burden of proof

15 Before the holding in Newark Morning Ledger Co. v. United States, supra, the Government had generally taken the position, as a matter of law, that many intangibles were part of goodwill. In Newark, the Supreme Court identified several customer-based intangibles which had been the subject of prior controversy, including “customer lists, insurance expirations, subscriber lists, bank deposits, cleaning service accounts, drugstore prescription files, and any other identifiable asset the value of which obviously depends on the continued and voluntary patronage of customers.” Id. at 557. The Supreme Court did not list brokerage accounts as one of the intangibles that had been in controversy; however, respondent has agreed that they “appear to be in the category of identifiable assets whose value depends on continued patronage of customers.” - 33 -

is great and will often be “too great to bear.” Id. at 566. To

that end, respondent argues that newspaper subscribers agree to

pay a flat rate, whereas brokerage customers do not pay unless

they trade, and whether they trade is not predictable. Finally,

respondent argues that the commission paid by traders (brokerage

customers) is not fixed but variable. Those differences,

respondent argues, make petitioner’s burden so great that, on

this record, it could not show and has not shown entitlement to

depreciation of the customer list acquired from Rose.

Petitioner counters that respondent’s argument is flawed

because brokerage customers are identified individuals who

maintain an established business relationship with the brokerage.

Petitioner also points out that newspaper subscribers do not pay

in advance, are not indebted to the newspaper, and may terminate

the delivery agreement by simple notification. By contrast, many

brokerage customers have cash and securities on deposit with the

broker, and those who purchase on margin have a debtor-creditor

relationship with the broker. In addition, termination of a

brokerage relationship requires both the customer and the broker

to take certain specified actions prescribed by Federal and State

securities commissions. Respondent also argues that revenues

from brokerage customers are variable and dependent on market

forces, whereas revenue from newspaper subscribers is relatively

fixed. Paradoxically, respondent’s expert’s prediction of income - 34 -

from the Rose customer accounts, based on Rose’s income and

petitioner’s customer data, was exceptionally accurate, showing

that the income was readily predictable.

Petitioner has shown that the acquired and acquiring

brokerages had essentially the same discount approach to business

and that Rose’s customers and petitioner’s customers were

categorized and treated similarly. Petitioner has also shown

that it was able to separate the Rose customer accounts from the

Rose infrastructure and that the Rose name and operational know-

how were completely abandoned. Therefore, the customer accounts

have been shown to be an exploitable asset distinct from the

generalized umbrella of “goodwill” that may have existed in the

Rose business and name.

In the setting we consider here, the brokerage customer

accounts are valued according to their potential to generate a

future income stream, and petitioner has shown that they are

distinct from goodwill and have a limited useful life. See,

e.g., Citizens & S. Corp. v. Commissioner, 91 T.C. 463, 500

(1988). In particular, the brokerage customer accounts were the

only asset of value acquired from Rose, and most of the remaining

assets acquired from Rose, including the “Rose” name, were

abandoned. Accordingly, and as discussed later in this Opinion,

petitioner has shown that the customer accounts can be valued and

that they waste “over an ascertainable period of time”. Newark - 35 -

Morning Ledger Co. v. United States, 507 U.S. at 566. We agree

with petitioner that brokerage customers are not, per se,

distinguishable from newspaper subscribers in any way that would

make the circumstances we consider here distinguishable from

those in Newark.

C. The Value and Useful Life of the Intangibles Petitioner Acquired

1. In General

Having decided that the Rose customer accounts are

amortizable under section 167, we now turn to the question of the

values or amounts that are subject to amortization and the useful

lives of the assets. On these points the parties have relied on

expert witnesses to provide opinion evidence based on the factual

record. Generally, the parties’ experts used similar methodology

to arrive at the values of the Rose customer accounts. The

experts attempted to compute the net revenue stream that

petitioner could expect from the Rose customer accounts. Both

used petitioner’s data of customer performance in petitioner’s

business16 and applied the Rose revenues that were generated in

the year before the acquisition.

16 Respondent argues, however, that Rose’s experience would be preferable and that petitioner’s experience was used because Rose’s experience was not available. - 36 -

Petitioner relies on J. Henry Knoblick of Deloitte, who had

prepared the 1990 valuation analysis of goodwill petitioner

relied on to make allocations of the $181,376,869 MADSP.

Respondent relies upon Lee B. Shepard of Houlihan Lokey Howard &

Zukin, who prepared a report 10 years later (on May 2, 2000) in

anticipation of this litigation. Each report contains an opinion

regarding the March 31, 1989, values of Rose’s assets and the

useful lives, if any, of Rose’s customer accounts. Both of the

expert’s reports contain values with respect to the Rose customer

accounts; however, respondent’s expert concluded that the useful

lives of pension accounts could not be determined and,

accordingly, those accounts would not be amortizable.

Conversely, on the basis of petitioner’s experiences with each

type of discount brokerage customer, Mr. Knoblick arrived at a

useful life for each category of customer account acquired by

petitioner.

The following chart compares the variations in the experts’

opinions as to the fair market values17 and useful lives to be

17 In the comparative chart, petitioner’s values are reallocated from the $181,376,869 Modified Aggregate Deemed Sales Price (MADSP) under the sec. 338 election. Petitioner’s values and resulting allocations did not result in any residual amount of goodwill. On the other hand, respondent’s expert’s fair market values, if found to be correct, would represent the maximum amount that petitioner would be able to allocate under sec. 338. Because the values respondent reached are approximately $35 million less than the $181,376,869 MADSP, the result under respondent’s approach would be $35 million in (continued...) - 37 -

assigned to the intangibles, including the customer accounts that

were acquired from Rose:

Respondent’s Life Petitioner’s Life Account Expert’s Value Years Expert’s Value Years

Cash $610,000 5.0 $4,014,000 4 1 1 Cash management 830,000 10.3 Margin 500,000 4.3 6,522,000 6 2 Pension 410,000 2,051,000 15 Vendor agreements 50,000 5.0 575,000 5 Marketing 250,000 3.0 671,000 3 agreements 2 2 Exchange seats 750,000 661,000 2 3 3 Trademark 600,000 3 3 Software 775,000 5.0 Total 4,775,000 14,494,000 1 Respondent’s expert separated the cash accounts into cash and cash management accounts to comport with Rose’s business approach. However, petitioner’s expert retained petitioner’s classifications, which had no separate breakout for “Cash management” accounts. 2 Respondent’s expert opined that the useful lives of these intangible assets could not be determined. 3 Petitioner’s expert did not value or assign lives to these intangibles on the premise that they had no value and, as evidenced in the record, petitioner discarded or abandoned them.

Respondent’s expert valued Rose’s tangible and intangible

assets (other than goodwill) at $146,280,000 on March 31, 1989,

whereas petitioner’s expert’s value was $181,837,000.

Petitioner’s fair market value was close to the $181,376,869

MADSP that petitioner allocated to its acquired assets, leaving

no residual amount of “goodwill”. Respondent’s expert’s value of

17 (...continued) goodwill. For purposes of comparison, this chart reflects the spread between the parties’ and their experts’ positions. - 38 -

$146,280,000 results in a residual of approximately $35 million,

which would be classified as goodwill and therefore be

unamortizable.

Concerning the intangible asset valuation, a difference of

approximately $10 million exists between respondent’s expert’s

value of $4,775,000 and petitioner’s expert’s value of

$14,494,000. A substantial portion of that difference is

attributable to the experts’ valuations of the customer accounts.

Respondent’s expert valued the aggregate of the customer accounts

at $2,350,000, whereas petitioner’s expert’s value was

$12,587,000. Accordingly, in our consideration of the value of

the intangibles, our primary focus is upon the acquired customer

2. Valuation of Customer Accounts

Under a section 338 election, the cost of the Rose shares

allocated to an individual asset may not exceed the fair market

value of the asset. Respondent contends that petitioner’s expert

did not use the standard for fair market value set forth in

section 1.170A-1(c)(2), Income Tax Regs., and section 20.2031-

1(b), Estate Tax Regs., to wit: The price at which the property

would change hands between a willing buyer and a willing seller,

neither being under any compulsion to buy or sell and both having - 39 -

reasonable knowledge of relevant facts.18 That standard assumes

a hypothetical buyer and seller so as to employ an objective

standard that would avoid “the uncertainties that would otherwise

be inherent if valuation methods attempted to account for the

[idiosyncracies of the particular seller or buyer]”. Propstra v.

United States, 680 F.2d 1248, 1252 (9th Cir. 1982).

Respondent contends that petitioner’s approach to value is

not objective and does not take into account the hypothetical

buyer and seller standard set forth in the regulations.

Continuing in that vein, respondent contends that petitioner’s

expert failed to take into account the intangibles, such as

goodwill, and merely focused on the potential for an income

stream from Rose’s customer accounts.

Respondent’s wooden reliance on the definition19 of fair

market value in section 1.170A-1(c)(2), Income Tax Regs., and

section 20.2031-1(b), Estate Tax Regs., misses the point.

Respondent ignores the fact that there was an actual purchase of

Rose by a willing buyer who was not under any compulsion to buy--

18 We note that respondent made the same argument with respect to petitioner’s use of its own experience with respect to the useful lives of the acquired Rose accounts. Our comment with respect to the issue of value apply equally to both arguments. 19 Sec. 338 contains no reference to that definition and provides no definition for purposes of the allocation of stock purchase price to acquired assets. In addition, sec. 338 permits taxpayers to allocate a portion of the acquisition cost to each asset in an amount that does not exceed the fair market value of the asset. - 40 -

petitioner. That buyer (petitioner) determined the amount it was

willing to pay for Rose on the basis of the realities and

pressure of the marketplace and its objective analysis of the

value residing in the assets or operations of Rose. As the

record reflects, petitioner was one of only a few potential or

possible buyers who would be able to use Rose’s principal asset

of value--its customers. Under the circumstances of these cases,

Rose’s customer base was the essence of its total value. The

rest of its assets, including the intangibles, were without

value. After the acquisition of Rose, petitioner did not attempt

to sell the “Rose” name or know-how. Petitioner abandoned those

assets and aspects of the Rose business simply because they had

no value to petitioner or anyone else.

Respondent would have us carry the hypothetical standard to

an academic level where the realities of the marketplace are

ignored. A “hypothetical sale should not be constructed in a

vacuum isolated from the actual facts”. Estate of Andrews v.

Commissioner, 79 T.C. 938, 956 (1982); see also Estate of True v.

Commissioner, T.C. Memo. 2001-167; Luce v. United States, 4 Cl.

Ct. 212, 220-221 (1983). In Caracci v. Commissioner, 118 T.C.

379, 392 (2002), we held:

A hypothetical buyer may be one of a class of buyers who is positioned to use the purchased assets more profitably than other entities. Accordingly, we have held that fair market value takes into account special uses that are realistically available because of a - 41 -

property’s adaptability to a particular business. Stanley Works v. Commissioner, supra at 400 [87 T.C. 389 (1986)]. Acknowledging the existence of such businesses in the universe of hypothetical buyers also is consistent with the standard that assets are not valued in a vacuum but, instead, are valued at their highest and best use.

Respondent would have us ignore the arm’s-length sale

between petitioner and Chase and instead attempt to estimate some

price of each individual asset, assuming it had value or that

there was a buyer willing to pay more than petitioner.

Petitioner’s evaluation of Rose’s assets was conducted in the

context of an actual transaction where the constraints of the

marketplace were brought to bear on petitioner’s approach to

value.20 In that regard, petitioner’s valuation was also

contemporaneously conducted under actual business conditions, and

we accept it at face. In this situation, there is no need to

conjure up a hypothetical buyer who is ignorant of the facts or

to attempt to place a value on goodwill where it did not exist.

To better understand the differences in value proposed by

the parties, we consider their experts’ reports and approaches.

In reaching our holdings on fair market value, we consider the

expert witnesses’ reports. It is within this Court’s discretion

20 Respondent’s expert concluded that $35 million of the $181,376,869 MADSP represented goodwill. The facts reflect that the Rose business was a service business which did not rely on capital, and its customers were the heart of its value. The Rose entity was financially troubled and did not have the intrinsic goodwill of a going concern. - 42 -

to evaluate the cogency of their conclusions and opinions.

Sammons v. Commissioner, 838 F.2d 330, 333 (9th Cir. 1988), affg.

on this point and revg. on another ground T.C. Memo. 1986-318.

This Court evaluates opinions of experts in light of each

expert’s demonstrated qualifications and the evidence in the

record. Estate of Davis v. Commissioner, 110 T.C. 530, 538

(1998) (and cases cited thereat). Accordingly, this Court may

accept or reject all or parts of an expert’s opinion. Id.

First, we consider petitioner’s expert’s (Mr. Knoblick’s)

approach to valuing the customer accounts acquired from Rose. He

began by comparing Rose’s designated categories of customer

accounts with those petitioner used and determined, with one

exception, that both companies used similar categories to

characterize their customers. Mr. Knoblick next analyzed Rose’s

annual (12-month) income for each of its categories of customer

accounts for the period ended March 31, 1989.

Mr. Knoblick then determined the useful lives of the

acquired accounts on the basis of petitioner’s experiences with

similar discount brokerage customer accounts. He used

petitioner’s data because Rose’s data was not available and, more

significantly, because petitioner’s data would be a more accurate - 43 -

measure of useful life since the Rose customers were to be

integrated into petitioner’s business environment.21

Mr. Knoblick then focused on Rose’s annual revenues from

cash and margin accounts, which were determined to be $6,183,294

and $6,765,276, respectively. Those amounts were adjusted to

account for petitioner’s revenue growth by employing a 12-percent

increase over each 4-year period. This 12-percent adjustment was

based on petitioner’s actual financial performance. Thereafter,

pretax earnings were determined by applying the pretax profit

margins petitioner used in its evaluation of the Rose business

entity at the time of purchase. The use of petitioner’s pretax

profit margins accounted for capital burden, including the fixed

and overhead costs of servicing the acquired Rose accounts.

Applying a 34-percent Federal tax rate, Mr. Knoblick derived an

after-tax income stream. He then applied a 16-percent discount

in order to determine the present value of the income stream.

Mr. Knoblick’s use of the 16-percent discount was based on its

use by petitioner’s acquisition team in their pre-purchase

analysis of Rose. Using that methodology, the fair market values

of Rose’s cash and margin customer accounts were determined to be

21 Petitioner followed the procedures for useful life set forth in sec. 1.167(a)-1(b), Income Tax Regs., as more fully discussed later in this Opinion in the section addressing useful life. - 44 -

Respondent’s expert (Mr. Shepard) valued cash and margin

customer accounts using a different approach from Mr. Knoblick’s.

As previously noted, Mr. Shepard divided the valuation of the

cash and margin accounts into three categories to comport with

classification that had been used by Rose, whereas Mr. Knoblick

used two categories to comport with petitioner’s classification.

Mr. Shepard valued the cash accounts at $610,000, with a 5-year

useful life; margin accounts at $500,000, with a 4.3-year useful

life; and cash management accounts at $830,000, with a 10.3-year

useful life.

The most significant difference between the approaches of

Messrs. Shepard and Knoblick is to be found in their perspective.

Mr. Knoblick valued the Rose accounts on the basis of empirical

information derived from petitioner’s account experience. Mr.

Knoblick reached the conclusion that the customer accounts were

the only assets that were of value to a buyer. Mr. Shepard,

however, used a more theoretical approach by valuing Rose as a

going concern under traditional methods of valuing Rose’s

business income and cash-generating capacity. He used that

approach even though his report contains information about Rose’s

poor performance and weak financial condition. Mr. Shepard, in

his valuation, focused on the volatile nature of the equities

market and a low point in the market during October 1987. Mr.

Shepard’s use of those factors resulted in an unnecessarily lower - 45 -

value for the customer accounts and operating assets. Because of

the approach required under section 338, where cost is first

allocated to depreciable assets and then to nonamortizable

(goodwill) intangibles, Mr. Shepard’s approach is inherently

unfavorable to petitioner because it results in a larger residual

in the category of goodwill.

In spite of Rose’s unprofitability and financial

difficulties, Mr. Shepard’s approach focuses on Rose as a going

concern, including an evaluation of the goodwill connected with

the Rose name and know-how. We cannot accept Mr. Shepard’s

approach under the circumstances reflected in the record of these

cases. The facts in these cases reflect that a willing buyer

would be interested in Rose’s customers and not be interested in

Rose as a going concern. It is also unlikely that Rose, a

service business, would have had value in the form of goodwill,

because Rose’s assets, other than the large number of customer

accounts, were not unique or capable of generating income, and

the universe of theoretical willing buyers was limited to another

discount brokerage with the capacity to use a large volume of

active customers. Such a “willing buyer” would be interested in

the potential for income from the exploitation of Rose’s discount

brokerage customers and have little or no interest in the use of

the Rose name. - 46 -

The universe of theoretically potential buyers was limited.

Although Rose was the smallest of the top five discount brokerage

firms, its business represented a 2.8-percent market share of

discount brokerage customers. Petitioner, on the other hand, was

the largest of the discount brokerages, and its nearest

competitor, Fidelity, had a 17.8-percent market share. Because

of the relatively large number of customers serviced by Rose, it

is unlikely that any discount brokerage other than the top few

would have the operating capacity or ability to absorb and

effectively and profitably use such a large customer base. It

was the potential for customer capacity and the potential synergy

of customer absorption that made the large discount brokerages

the willing buyers and produces the benchmark for the fair market

value of Rose’s customer accounts. Respondent would have us

ignore this established fact and value the accounts in a manner

that would give value to assets that were of no import to

potential purchasers.

Rose’s customers represented its only income-generating

asset. Rose’s infrastructure and name would be of no consequence

or interest to potential buyers, who, of necessity, had to be

larger entities with successful operations and name recognition.

Under these circumstances, respondent’s expert’s going-concern

approach to value is incongruous and unhelpful. - 47 -

On the other hand, the approach petitioner’s expert used in

his report is more apropos of the circumstances we consider and

was contemporaneously used by petitioner in connection with its

evaluation and acquisition of Rose and reporting of the

transaction. In addition, Mr. Knoblick’s methodology was based

on brokerage industry experience. Under those circumstances, we

find Mr. Knoblick’s report to be more appropriate and reliable.

We were also influenced by the fact that Mr. Knoblick’s approach

and report do not appear to inflate or reach merely to favor

petitioner’s position. Conversely, Mr. Shepard’s approach

appears to ignore the realities we consider and inappropriately

attempts to focus on a going-concern value to establish value for

assets which petitioner (as well as any other “willing buyer”

would have) abandoned.

Frequently, valuation cases engender intermediate results

where the opinion of each party’s expert is brought to bear.

This instance, however, is one where full faith and credit should

be given to the expertise proffered by one of the parties. We

accept Mr. Knoblick’s report and hold for petitioner on the

question of value. In a like manner, the reliability of the

results reached by Messrs. Shepard and Knoblick is repeated with

respect to the valuing of the remaining customer accounts and

assets. - 48 -

3. Useful Lives of Customer Accounts

Respondent uses a two-pronged approach in his argument that

petitioner has not shown the useful lives of the Rose customer

accounts. First, respondent argues that petitioner is limited to

using Rose’s historical data to determine the useful lives of the

acquired accounts. If the Court decides that petitioner is

entitled to use its own historical data, respondent argues that

petitioner has misapplied its data to Rose’s accounts.

It is not surprising that the use of petitioner’s historical

account life data resulted in the parties’ experts reaching

generally similar useful lives for the Rose customer accounts in

similar categories. So, for example, with respect to cash and

margin accounts, respondent’s expert concluded that the useful

lives were 5 and 4.3 years, respectively, whereas petitioner’s

expert concluded that the useful lives for the same categories

were 4 and 6 years, respectively. Likewise, with respect to the

vendor and marketing agreements, the parties’ experts both

concluded that the useful lives were 5 and 3 years, respectively.

The similarities result from the fact that both parties’

experts used petitioner’s account life experience in their

analysis because there was a paucity of information available

from Rose regarding the acquired accounts. The major difference

between the experts’ approaches as to useful life is attributable

to their categorization of the accounts. Although both experts - 49 -

used petitioner’s useful lives experience, they used different

categories within which to analyze the useful lives of the

accounts. Respondent’s expert sought to replicate Rose’s

categories for its accounts, whereas petitioner’s expert used

petitioner’s categorization.

That difference resulted in respondent’s expert’s carving

out one more category than petitioner’s expert had. Respondent’s

expert used a 10.3-year life in a category that did not exist in

petitioner’s business practice or nomenclature. In addition to

those differing approaches, the parties disagree about the

interpretation and application of a regulation providing for

approaches to be used in determining the useful lives of acquired

assets.

In particular, section 1.167(a)-1(b), Income Tax Regs.,

requires the use of a taxpayer’s experience with respect to the

useful lives of similar property in order to determine the useful

life of an acquired asset.22 In these cases, petitioner and

22 Sec. 1.167(a)-1(b), Income Tax Regs., in pertinent part, provides the following standards and approach for determining the useful life of “similar” assets:

For the purpose of section 167 the estimated useful life of an asset is not necessarily the useful life inherent in the asset but is the period over which the asset may reasonably be expected to be useful to the taxpayer in his trade or business or in the production of his income. This period shall be determined by reference to his experience with similar property (continued...) - 50 -

respondent both used petitioner’s useful life experience to

determine the useful life of the customer accounts acquired from

Rose.23 The parties disagree about the degree of similarity

necessary before a taxpayer can use its own experience to

determine the useful life of an acquired asset.

Respondent contends that petitioner is not entitled to use

its own experience because it has not shown that the acquired

Rose accounts are similar to petitioner’s accounts. To that end,

respondent argues that historical information was not available

on the Rose accounts and that the information that was available

reflected that Rose’s active accounts had declined and were older

than petitioner’s and that there were categorical differences

between them.24

Petitioner contends that Mr. Dodds’s testimony regarding the

similarity of petitioner’s and Rose’s accounts was sufficient to

22 (...continued) taking into account present conditions and probable future developments. * * * If the taxpayer’s experience is inadequate, the general experience in the industry may be used until such time as the taxpayer’s own experience forms an adequate basis for making the determination. * * * 23 Respondent argues that Rose’s experience should have been used, but that respondent’s expert was forced to use petitioner’s data because insufficient Rose data was available. 24 Respondent’s argument that the Rose customers varied substantially from petitioner’s customers is, to a great extent, paradoxical. Respondent acknowledges that there is insufficient Rose data. Notwithstanding that acknowledgment, respondent saw fit to argue that the Rose accounts are dissimilar from petitioner’s accounts. - 51 -

meet the spirit and letter of the subject regulation. Mr.

Dodds’s uncontradicted testimony reflected that there were some

differences in the categorization of accounts25 and in the

individual trading volume or activity of customers, but that the

clientele of both firms was substantially similar. Both were

discount brokerages, and they competed in the same market for

their clientele.

Petitioner also notes that respondent’s expert’s report,

using petitioner’s preacquisition revenue experience, resulted in

predictions of the postacquisition revenue stream from Rose

accounts with better than 80-percent accuracy in early years and

98-percent accuracy for the third and fourth years after

acquisition. Further, petitioner highlights the fact that it was

the leader in the discount broker industry with a 42.4-percent

market share. That fact made petitioner’s experience, within the

meaning of the regulation, sufficiently “adequate” to determine

the useful lives that the Rose accounts were likely to have in

the context of petitioner’s business.

Ultimately, the disagreement between the parties boils down

to the degree of similarity needed to invoke the use of one’s own

25 Specifically, Rose had more institutional customers. Respondent also argues that petitioner’s expert (Mr. Knoblick) used shorter lives in his analysis than were estimated by Mr. Dodds in connection with the preacquisition analysis of Rose. We pay little heed to respondent’s point because Mr. Knoblick’s analysis was based on an actuarial approach, comprising a complete historical analysis of all of petitioner’s accounts. - 52 -

experience regarding useful life. Respondent contends that a

high degree of similarity is required, whereas petitioner’s

approach implies that a reasonable amount of similarity is

sufficient. The regulation merely uses the term “similar

property” without describing any particular degree of similarity.

As a practical matter, petitioner’s experience with discount

brokerage customer accounts is vast. The record we consider,

including Mr. Dodds’s testimony, does not differentiate, in any

meaningful way, among the accounts or customers of the various

brokers within the universe of discount brokerages. On that

basis alone, we believe that it would be prudent to hold that the

Rose accounts were sufficiently similar to permit petitioner to

invoke the use of its useful life experience under section

1.167(a)-1(b), Income Tax Regs.26

Petitioner also references a case where this Court held that

comparable assets were sufficient to meet the “similar”

requirement. In Colo. Natl. Bankshares, Inc. v. Commissioner,

T.C. Memo. 1990-495, affd. 984 F.2d 383 (10th Cir. 1993), the

Court recognized that NOW bank accounts were relatively new with

little data available on their useful life. Recognizing that

26 Petitioner also notes that the regulation provides that in situations where a taxpayer’s experience is not adequate, industry experience is to be used. In that regard, petitioner states that no such industry study exists but rationalizes that petitioner’s experience would dominate any industry study because of its 42.4-percent market share. - 53 -

fact, this Court held that checking and savings accounts were

similar to NOW accounts for purposes of section 1.167(a)-1(b),

Income Tax Regs. We have little difficulty using the same

reasoning here; i.e., discount brokerage customers are

generically similar enough for purposes of the regulation to

allow petitioner to use its own data to determine the useful

lives of the acquired customer accounts.

Respondent also relies on the Colo. Natl. Bankshares case

with respect to the method used to analyze the useful life of

acquired bank deposits. Respondent points out that the Court

relied on the historical data on deposits where it was available.

Where the data was missing, however, the life of the acquired

deposits was estimated on the basis of the historical data of

other banks. The object lesson of that rationale, however, is

that historical data of the acquired asset is not essential to

determining similarity. Indeed, the regulation itself permits

industry experience as a substitute.

Respondent also argues that Colo. Natl. Bankshares shows

that deposits at different banks “behaved” differently and, on

the basis of that fact, respondent contends we should expect that

Rose’s discount brokerage accounts would not necessarily be

similar to those of petitioner. We cannot rely on such analogies - 54 -

without some factual predicate in this record. The record we

consider, especially Mr. Dodds’s testimony, supports a contrary

factual finding.

Central to the structure and approach of section 1.167(a)-

1(b), Income Tax Regs., is the use of the acquiring taxpayer’s

experience to determine useful life because the acquired asset

will probably perform like similar property in the context of the

acquirer’s business. Setting the similarity standard at an

extremely high level, as contended for by respondent, could

undermine the intended purpose of the regulation. There is

little question that petitioner’s customer accounts were

sufficiently similar to the acquired accounts to permit

petitioner to use section 1.167(a)-1(b), Income Tax Regs., in

determining the useful lives of the acquired accounts. We

sustain the useful lives petitioner derived.

Considering the parties’ experts’ approaches, we conclude

and hold that petitioner has shown sufficient similarity to use

its own useful life data and categorization to determine the

useful lives of the acquired Rose accounts. In addition, we hold

that petitioner’s approach in deriving the useful lives of the

acquired Rose accounts is reasonable and appropriately reflects

the useful lives for purposes of amortization.

Reiterating, for the acquired cash and margin accounts, Mr.

Knoblick performed an actuarial study of petitioner’s comparable - 55 -

account activity. He developed a survival curve reflecting the

rate of retirement and the age of the assets. The starting and

ending dates for all accounts in existence from 1975 to 1989 were

reviewed. On the basis of that analysis he determined that cash

and margin customer accounts had useful lives of 4 and 6 years,

respectively.

Mr. Knoblick used that same methodology to determine the

useful life of the pension customer accounts to be 14.66 years

(rounded to 15). For the same reasons as stated for cash and

margin accounts, we accept petitioner’s use of 15 years for the

pension customer accounts. We also note that we likewise accept

and hold that the fair market value of the pension accounts was

$2,110,000.

The value of Rose’s institutional customer accounts, which

represented a small portion of Rose’s customer accounts in actual

numbers and revenue, was allocated between the intangible assets

denominated “Chase Vendor Agreements” and “Chase Priority

Marketing Access Agreement”. The vendor and marketing agreements

were valued, as intangibles, at $592,000 and $690,000,

respectively, and were assigned tax bases of $575,000 and

$671,000, respectively. We also find for petitioner on those

valuations and useful lives.27

27 We note that our findings and holdings in these cases result in a total fair market value for the acquired Rose (continued...) - 56 -

In summary, we sustain the values and useful lives

petitioner advocates.28

To account for concessions of the parties and to reflect the

foregoing,

Decisions will be entered

under Rule 155.

27 (...continued) customer accounts of $12,951,000, which was adjusted to $12,587,000 for purposes of allocating petitioner’s acquisition cost to the tax bases of the assets under petitioner’s sec. 338 election. 28 Because we have sustained petitioner’s position with respect to the values and useful lives of the acquired intangible assets, it is unnecessary to consider petitioner’s argument that it is entitled to an abandonment loss with respect to the assets it disregarded in connection with the acquisition of Rose.