Fin 48 and State and Local Income Taxes

By Harlan J. Kwiatek, CPA, J.D., LL.M.

Scott Salmon, CPA, M.Acc.

The required adoption of Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), for enterprises with fiscal years beginning after December 15, 2006, has placed increased scrutiny on state and local income taxes. Given that in the past, state and local income taxes often played second fiddle to their federal and international income tax siblings, many CPAs are facing a big challenge in trying to determine how FIN 48 affects financial disclosure of their clients’ state and local income taxes. A number of questions, issues, concerns, and uncertainties make this analysis of state and local income taxes a difficult one.

For some CPAs, this may be their first encounter with some very technical and unusual terms and concepts, such as nexus, P.L. 86-272, solicitation, apportionment, allocation, intangible holding companies, and many others, that are at the heart of state and local income taxes. Instead of dealing with a single income tax code (as with U.S. federal income taxes), state and local income taxes are more akin to international taxes. Each state and local jurisdiction has its own income tax statutes, regulations, case law, and administrative practices, all of which seem to change on a regular basis. CPAs must consider these rapid changes when addressing state and local income tax positions. 

Two-Step Analysis

A FIN 48 analysis of income taxes—including state and local income taxes—is a two-step process of recognition and measurement. At the outset, a determination must be made that a particular state and local income tax position has a “more-likely-than-not” chance of being sustained, in which case recognition would be required in the financial statement. In the second step, for each such tax position that meets the recognition threshold, a determination must be made of the amount of tax benefit that should be recorded in the financial statement. FIN 48 uses a cumulative probability approach, recognizing the largest amount of the tax benefit that is greater than 50% likely to be realized on ultimate settlement with a taxing authority having full knowledge of all relevant information.

Unit of Account

Key to the FIN 48 analysis of state and local income taxes is the identification of the “unit of account,” which is the level at which a tax position should be analyzed. A state and local income tax position can have multiple elements or parts that are interrelated, with varying implications for the expected tax exposure or benefit. Therefore, the selection of a unit of account can affect the amount of tax exposure or benefit that may be recognized in the financial statements. While there are few concrete guidelines in this area, one practical consideration that should be weighed for state and local income tax purposes is the level of variation that may exist among the states in scrutinizing a particular tax position. If the state and local income tax position is one that many jurisdictions would scrutinize in a similar manner, it is possible that taking that tax position in multiple jurisdictions should be viewed as a single unit of account. This potentially could include tax positions as basic as certain common state modifications to federal taxable income, such as bonus depreciation decoupling or the state income tax addback, or as complex as transfer pricing between related entities. Alternatively, the determination of the proper unit of account may be much more complex for tax positions that tend to be scrutinized by the states in a more diverse manner, such as whether a deduction for related-party royalties or interest should be allowed, due to greater variation in the applicable provisions (e.g., differing levels of applicability, differing exceptions to applicability, etc.).

What Is a State Income Tax?

The threshold question of what is a state income tax for FIN 48 purposes also can be complicated because of the many variations of tax im-posed at the state and local level. Various state and local taxes may have “income tax-like” elements that potentially can belie their nomenclature as something other than an income tax. Taxes formally referred to as business and occupation, alternative minimum, privilege, capital, net worth, replacement, single business, and franchise taxes all may require scrutiny of their essential elements. For example, consider the Texas franchise tax, which historically has been equal to the greater of a tax imposed on an entity’s net taxable capital (i.e., a net worth tax) or its net earned surplus (i.e., a net income tax). The challenging question for a CPA conducting a FIN 48 analysis is determining if the historic Texas franchise tax should be considered a state income tax, especially if the taxable entity may not be subject to the net earned surplus portion of the tax. In addition, Texas is changing its taxing system beginning with tax years ending in 2007 from the tax described above to a “margin” tax (i.e., a tax based on gross receipts with certain allowable deductions, such as cost of goods or compensation). With this change, the Texas franchise tax requires renewed scrutiny and could have different implications from a FIN 48 perspective.

Other state taxes applicable to businesses, including sales and use taxes, property taxes, and unusual state tax systems like Washington’s business and occupation tax and Ohio’s commercial activity tax, typically are not considered to be income taxes. While Michigan’s single business tax (repealed as of December 31, 2007) often is not considered to be an in-come tax, arguments potentially can be made for the opposite conclusion, due to its federal taxable income starting point. Similar to Texas, the successor taxing regime in Michigan (the business income tax, modified gross receipts tax, financial institution franchise tax, and insurance premium tax, as applicable) that is effective on January 1, 2008, will require scrutiny to determine those components that should be considered an “income tax” for FIN 48 purposes.

Local jurisdictions (including many cities and some counties) also may impose a tax on earnings or net in-come that should be examined. For example, the St. Louis (Missouri) city earnings tax is based on net income and likely should be considered an income tax for FIN 48 purposes.

Requirement to Pay State Income Tax

In a FIN 48 analysis of federal income tax positions, it would be fairly unusual to have to consider “nonfiling” positions. However, an enterprise’s requirement to pay income taxes to a particular state or local jurisdiction (i.e., its “nexus” with the jurisdiction) often is debated. As a result, many businesses have income tax exposure for nonfiling, and this area becomes an important part of the overall FIN 48 analysis. It also introduces a number of unique considerations.

One issue for a business in a nonfiling situation is determining the extent of the exposure. Because a state or local jurisdiction’s statute of limitation generally does not start running unless a return has been filed (even if the nexus with the jurisdiction is debatable), the “lookback period” (i.e., the number of years on which the jurisdiction could assess tax) for analyzing the tax exposure could be significant.

For example, consider the case of a business that sells tangible personal property. Federal legislation enacted almost 50 years ago (P.L. 86-272) pro-vides such companies with limited protection from a state’s requirement to pay income tax. In general, the protection is limited to a company that solicits sales of tangible personal property in a state, sends orders outside the state for acceptance, and delivers the product to the customer from a point outside the state. Because of the narrow protection afforded (note that it is inapplicable not only to service businesses, but also to many businesses that fit the general profile but have in-state activities exceeding pure solicitation), a company may engage in business in a state for many years and be exposed to state income tax as a result of exceeding the parameters of P.L. 86-272. As a result, a CPA must assess the proper lookback period to use in analyzing the tax exposure.

One factor in this analysis can be programs that states provide to limit the lookback period for nonfilers that voluntarily come forward. For example, most (if not all) jurisdictions have voluntary disclosure programs available for businesses that voluntarily contact the jurisdiction to clarify their nexus status. The programs generally limit the lookback period for nonfilers, often eliminate penalty assessments, and may reduce the exposure to interest. Similarly, a state or local jurisdiction may enact a tax amnesty program—Texas concluded one in August 2007—that operates in a similar manner and offers similar terms to a voluntary disclosure program. If a business is willing to pursue these options, amnesty provisions that are either currently in place or set to commence in the near future or voluntary disclosure programs may affect the tax exposure analysis.

When an amnesty or voluntary disclosure program is unavailable or the client is unwilling to pursue such an avenue, the question of the proper lookback period to use in assessing the potential exposure becomes less clear. FIN 48 allows for consideration of past administrative practices and precedents of a taxing authority in its dealings with similar enterprises if those practices and precedents are widely understood, but those policies as applied to nexus often can vary based on the situation involved. For example, a state or local jurisdiction may be more forgiving and more willing to limit the lookback period even on a jurisdiction-initiated audit, where the discovery of nexus is minor, easily overlooked, or debatable. How-ever, a jurisdiction is not likely to be as forgiving if the nexus was clear or related to the use of a tax-planning strategy, such as an intangible holding company. In such instances, a state or local jurisdiction may be inclined to pursue a longer lookback period.

Accordingly, a CPA will have to address a number of questions in this area. However, the most important factor in analyzing this area will be ascertaining those facts regarding the operation of an entity’s business that are relevant to the analysis and whether the full extent of those facts has been disclosed.

Other State and Local Income Tax Positions

There are other state income tax concepts that a CPA will have to address during a FIN 48 analysis, and many of these will differ from jurisdiction to jurisdiction. They include (but are not limited to) modifications to federal taxable income (including the treatment of federal or municipal interest income and the decoupling from some recent federal legislation), the availability and realization of state net operating losses, the allocation and/or apportionment of income, the composition of the apportionment formula, the appropriateness of business or nonbusiness income treatment, the availability and realization of tax credits, the use of alternate reporting methodologies (including unitary combination), the applicability of underpayment penalties, and the proper computation of interest due on potential exposures. In addition, potential benefits and exposures resulting from state and local income tax planning must also be considered during a FIN 48 analysis.

Intangible Holding Companies

Consider an intangible holding company. This once was a very popular state and local income tax planning idea that generally involved placing a business’s intangible assets in a subsidiary corporation that then charged a royalty fee to its related operating entities. The intangible holding company was often domiciled in a tax-favored jurisdiction, such as Delaware or Nevada, or a unitary combination jurisdiction.

In performing a FIN 48 analysis, a CPA not only will be required to understand the concept of an intangible holding company (something that is beyond the scope of this column) but will also have to be familiar with the ever-changing state tax laws, regulations, and court decisions that affect the state and local income tax treatment of such entities. Prominent among these developments are the use of business purpose/economic substance concepts, the pursuit of economic nexus, and the enactment of expense disallowance (i.e., “add-back legislation”) provisions by state and local jurisdictions.

There are varying degrees of substance in how intangible holding companies have been established and maintained. In some cases, an intangible holding company may be a viable and sustainable separate legal entity, engaging in business and activities with third parties and employing business developers and/or marketing personnel, research and development personnel, attorneys, accountants, and administrative staff. In other cases, an intangible holding company may have some, but not all, or varying levels of these characteristics. In other instances, many of these characteristics will be wholly absent. Determining those facts regarding the entity’s operation and whether all the facts have been disclosed will be critical to assessing, as a threshold matter, whether the intangible company potentially could be disregarded by a jurisdiction as lacking economic substance.

In recent years, many state and local jurisdictions have attacked in-tangible holding company tax planning by broadening their nexus statutes and regulations, so that a business that licenses the use of an intangible asset to a party within the jurisdiction is required to file an income tax return. Many states have taken this battle to the courts, arguing that the royalties received from licensees in the state create a sufficient “economic presence” to require the intangible holding company to pay income tax. The decisions of state supreme courts have differed by state. In South Carolina, intangible holding companies are subject to tax (Geoffrey Inc. v. South Carolina Tax Comm’n, 437 SE2d 13 (SC 1993)). In Missouri, without other nexus-creating activities, an intangible holding company likely is not subject to income tax (ACME Royalty Co. and Brick Inv. Co. v. Director of Rev., 96 SW3d 72 (MO banc 2002)). A recent decision by the New Jersey Supreme Court, for which certiorari was denied by the U.S. Supreme Court in June 2007, held that an intangible holding company is subject to taxation in New Jersey (Lanco, Inc. v. Director, Div. of Tax’n, 908 A2d 176 (NJ S. Ct. 2006), petition for cert. denied, U.S. S. Ct., Dkt. No. 06-1236, 6/18/07).

In an increasing number of jurisdictions, addback legislation exists, requiring a business paying royalties or interest to a related intangible holding company to add those deductions back to its taxable income. Currently, addback legislation can be found in Alabama, Arkansas, Connecticut, the District of Columbia, Georgia, Illinois, Indiana, Kentucky, Maryland, Massachusetts, Mississippi, New Jersey, New York, North Carolina, Ohio, Oregon, and Virginia. These provisions contain numerous exceptions to the general rule of disallowance. Again, detailed factual information will be required to assess the likelihood of a claimed exception being sustained.

In addition to the issues discussed above, the FIN 48 treatment of an intangible holding company involves many other issues, such as the potential for transfer pricing adjustments or alternate apportionment methodologies. The number of issues involved complicates the determination of whether a FIN 48 analysis of an intangible holding company itself involves a single unit of account or multiple, discrete units of account. Ultimately, a CPA will have to use his or her best judgment in analyzing such situations.


FIN 48 asks that state and local income tax positions be analyzed from the point of view of a full-knowing tax auditor. CPAs must readdress state and local income tax positions annually on a state-by-state basis. Prac-titioners charged with analyzing these positions are faced with many challenging decisions before recognizing and measuring each jurisdiction’s income tax position. The variation in state and local income tax systems and the continuing change in state and local income taxation currently present, and will continue to present, many difficult decisions when addressing FIN 48.

Mr. Salmon is the chair, and Mr. Kwiatek is a member, of the AICPA Tax Division’s State & Local Taxation Technical Resource Panel. For more information about this column, contact Mr. Kwiatek at
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