Trade date determines taxability of commission income.

Should broker-dealers who use an accrual-basis method of accounting be taxed on their commissions/income as of the trade date or the settlement date? This question has vexed Charles Schwab & Co. for the past 10 years. The Ninth Circuit recently affirmed the Tax Court's ruling that the trade date governs (Charles Schwab & Co., 9th Cir., 12/9/98, aff'g 107 TC 282 (1996)).

Schwab's original dispute with the IRS began with its 1988 corporate income tax returns. Schwab did not include commission income earned from trades that did not settle until 1989, taking the position that until the trades actually settled, the company did not yet have the right to receive this income.

When Does Income Recognition Occur?

Schwab explained its position to the Service by noting that it maintains its books and records under the accrual method of accounting, which requires income recognition when all the events have occurred that fix the right to receive income and amounts can be determined with reasonable accuracy.

On the "trade date," a customer's order is executed by locating a seller or purchaser for securities on terms acceptable to the customer. The date on which Schwab settles the account of a customer whose order to buy or sell securities has been executed is termed the "settlement date."

Settlement is the process of transferring payment from buyer to seller and certificates from seller to buyer. In 1988, the New York Stock Exchange required traders to settle transactions within five days after the trade date (currently, it is three days).

After a lengthy dispute, Schwab and the IRS finally brought the matter to Tax Court. Schwab argued that, after the execution of the trade and until the actual settlement, it had to perform a series of functions that included recording, figuring, confirming, comparing and booking.

Schwab argued that, without these functions, the company could not collect the commission and, therefore, did not yet have the right to receive the income.

Tax Court Supports IRS

The Tax Court ruled in favor of the Service, stating that Schwab's "execution of a trade for a customer is a condition precedent that fixes [Schwab's] right to receive commission income. The functions that remain to be performed by Schwab after the trade date are of a ministerial nature to effectuate the mechanics of the transfer and confirm the trade executed."

Further, the Tax Court stated that no customer can cancel an order executed in accordance with the customer's instructions, and a customer is liable only for the amount determined according to circumstances existing on the original trade date.

Schwab appealed to the Ninth Circuit, claiming that it was not entitled to receive the commission for effecting a purchase or sale until the settlement date. On appeal, the IRS argued that the Tax Court correctly determined that the essential service Schwab performed was executing the trade. The functions performed after the trade date were minor and involved bookkeeping matters. The fact that confirmation was needed was a mere incident of executing a trade.

The Court of Appeals agreed with the Tax Court; the mere possibility that a small percentage of executed trades may not go to settlement did not negate the critical fact that the commission was earned when the trade was executed on the trade date.

FROM ISRAEL PRESS, CPA, NEW YORK, NY