Recognizing and Measuring Tax Benefits From Uncertain Tax Positions

Editor: Albert B. Ellentuck, Esq.

Once all uncertain tax positions have been identified, FASB Accounting Standards Codification Subtopic 740-10 creates a two-step process to recognize and measure the tax benefits arising from those positions. An important factor in this analysis is that the information considered must be available on the reporting date. Subsequent information cannot be used to assist in recognizing the tax benefit. Information that becomes available after the reporting date, but before the financial statements are issued, should not be used in assessing any tax benefit. However, as discussed later, that information will be used in reassessing the tax benefits in subsequent periods.

Meeting the More-Likely-Than-Not Standard

If the more-likely-than-not (MLTN) standard is not met, no tax benefit can be claimed. If, however, the MLTN standard is met, the client and practitioner must then determine the tax benefit to recognize.

Example 1. Meeting the MLTN standard: B Inc. has been aggressive in deferring income to future years from the sale of services. In 2015, B deferred $1 million to 2017, resulting in a tax benefit in 2015 of $350,000. Upon analysis, B concludes that this position does not meet the MLTN standard. Accordingly, B cannot recognize the $350,000 tax benefit in 2015. Its financial statements will show an unrecognized tax liability of $350,000.

The recognition requirement is met if it is more likely than not that the client’s position will be sustained in a dispute with the appropriate taxing authority. Clients and practitioners must consider the impact of the decision on a variety of taxing authorities. For example, a depreciation decision might involve consideration at both the federal level and the state level. On the other hand, an allocation of income among four states would only involve the various state taxing authorities.

Deciding whether a tax position meets the MLTN standard must be based on the technical merits of the position. The analysis of the position must consider the underlying statute, tax treaty, committee reports (indicating legislative intent), regulations, administrative rulings, and case law as those authorities are applied to the facts and circumstances in the tax position. This requires both a good understanding of the facts, as well as a thorough analysis of the applicable tax law. Additionally, the client and practitioner must assume that the taxing authority and the examining agent will have full knowledge of all relevant information. The analysis must support the conclusion that the client is more likely than not to prevail if the position is challenged and the case is heard by the court of last resort. However, as discussed later, the measurement of the tax benefit is based on the tax benefit likely to be realized upon ultimate settlement with the pertinent taxing authority. This means that the MLTN standard is actually higher than the measurement standard. To recognize any benefit, the client must believe it is more likely than not that the court of last resort would sustain the position. However, in determining the amount of tax benefit to recognize in the financial statements, the client can base that benefit on what tax deduction the taxing authority might likely allow in a settlement.

The court of last resort will depend on the tax position and rights the client has to litigate the decision of the taxing authority. For federal decisions, it would seem that the court of last resort would be the U.S. Supreme Court. However, there is no right of appeal to the ­Supreme Court. Instead, the Court grants a writ of certiorari upon a request by a party for a hearing. Thus, for federal tax issues, the better answer is that the court of last resort is the circuit court that has jurisdiction over the client. For state tax issues, the state supreme court would be the court of last resort.

What makes this process so troubling is that any court decision, other than that of the court of last resort, should theoretically be disregarded if the court of last resort has not ruled on the matter. In fact, one could conclude that such cases cannot be relied on unless the client finds the lower court’s decision and reasoning persuasive or believes that the court of last resort would find the reasoning persuasive, when applied to the client’s facts.

Within these parameters, the client and practitioner must determine whether the client is more likely than not to prevail on each uncertain tax position. Remember, however, that in making that determination, the taxing authority must be assumed to be in full possession of all relevant information. Subtopic 740-10 also makes it clear that the analysis must be of statutory or other legal authority, not the experience of another company.

Example 2. Considering nonstatutory or legal authority: C Inc. is analyzing whether an uncertain tax position meets the MLTN standard. Unfortunately, there is virtually no statutory authority or case law on the issue. However, C knows that another company, V Co., took the same position on its tax return, and the IRS accepted that position on audit. C cannot consider the audit results in determining whether the MLTN standard is met since the results of that audit do not constitute legal authority.

An important distinction between the Subtopic 740-10 analysis and the usual tax planning analysis is the higher threshold that must be met for Subtopic 740-10. Normally, a client can file a tax return if there is substantial authority for the tax position or if the client has a reasonable basis for the position and discloses the position. Likewise, a practitioner can sign a return if the position has substantial authority or if the practitioner has a reasonable basis for the position and discloses that position. In either case, the standard has less than a 50% chance of success. In Subtopic 740-10’s case, the evidence and analysis must lead the client to conclude that the position has a better than 50% chance of success. This higher standard requires a careful analysis and comparison of the cases, administrative rulings, etc., with the facts in the client’s case.

Weighing the Various Authorities

Having completed the research, analyzed the facts, and drawn conclusions about how close the facts are to those in the researched material, the next step is to weigh the various authorities. This is not, as it might seem, the easiest part of the process. Instead, it is often the most difficult, because there will likely be contradictory rulings, cases, and even regulations. Sorting out which authorities are more important, which should be given greater weight, and which can be disregarded is not easy. The following are some considerations for a practitioner in determining the weight to give a case or other authority:

• Age of the authority: As a general rule, the older a ruling or case is, the less weight it should receive. Be careful, though, since a lack of a more recent case or ruling may mean that the law is so well-settled that there has not been any additional controversy about the matter. But if older rulings or cases reach one conclusion and more recent cases or rulings reach the opposite conclusion, greater weight should be given to the more recent authorities.
• Has the Internal Revenue Code provision or state statute that was the focus of the case or ruling been changed? If so, how did the change affect the old provision? If the change was merely a clarification, then the authority should still be valid. In fact, if Congress or the state legislature kept the same language that was the subject of the case or ruling, then a strong argument exists that the legislation implicitly adopted the conclusion in the case or ruling.
• Does the court or administrative agency rendering the decision have jurisdiction over the client? If so, then the authority should be accorded a great deal of weight, since the decision will most likely be consistently applied to all cases or situations brought before that tribunal.
• For a court decision, where in the judicial hierarchy does the court rendering the decision stand? For example, a U.S. circuit court decision should be accorded more weight than a U.S. district court case. However, where the court of appeals to which the client’s case would be appealed has not ruled on the matter, a district court decision may have substantial weight where it is in line with any other circuit’s decisions.
• Is the law well-settled? If the authorities all come to the same conclusion, great weight can be given to the conclusion. When there are several authorities reaching one conclusion and one or two reaching a different conclusion, the weight to be accorded the different conclusions will likely depend on how close the client’s facts are to the facts in the various cases or rulings.
• What is in conflict? Identifying where the conflicting decisions are by courts, then analyzing the hierarchy of the courts helps determine the weight a decision should receive. However, when the IRS or state administrative agency is in conflict with a court decision, additional analysis is required. For example, if the IRS holds one position, and that position is repeatedly rejected by the courts, the IRS position arguably has little weight. However, bear in mind that the value of the tax benefit may then hinge on whether the client is prepared to litigate the issue, since the IRS will certainly stand firm on its position. When the IRS position has been consistent and the courts have split in supporting it or rejecting it, the weight to place on the IRS position is very difficult to determine.
• How much weight does the statute give the administrative agency’s rulings? This can be a crucial piece of knowledge, since a presumption of correctness makes the ruling very difficult to overcome. The federal courts do not automatically defer to IRS rulings when it comes to interpreting the federal tax law. However, many states’ statutes provide that a tax commissioner’s conclusion is presumptively correct, which increases the weight that should be given to the ruling.

Given the complexity of the tax law, the more logical and thorough the reasoning in the ruling or case, the more weight it should receive.

Measuring the Tax Benefit

If the MLTN standard is not met, no tax benefit can be recognized. Once, however, the MLTN standard has been met, the value of the tax benefit must be calculated. The measure of a tax benefit meeting the MLTN standard is the largest cumulative tax benefit that has a greater than 50% chance of being realized. Stated another way, the benefit recognized equals the smallest total benefit that exceeds the MLTN standard. This requires an analysis of possible outcomes and the probabilities of those outcomes. The calculation is probably best ­illustrated by the table in the exhibit below.

Using this information, Subtopic 740-10 would require recording a tax benefit of $2,350, which is the largest cumulative benefit that has a more than 50% probability of being recognized. The creation of a list of probabilities presupposes that the client (or tax professional) has analyzed both the facts and the pertinent tax law in reaching the conclusions as to the likely outcomes. This will involve a substantial amount of subjectivity, since the tax law is rarely clear in new or complicated situations, particularly when the facts play a critical role in what the tax consequences of a transaction will be.

In calculating the expected tax benefit, the following considerations may prove helpful:

• Consider how close the client’s facts are to the facts in the authorities supporting the client’s position. The closer the facts, the higher the benefits that can be recognized.
• When documentation is a critical part of a tax position (i.e., reasonable compensation), review and weigh the likelihood the client’s documentation properly supports the deduction.
• Consider the client’s and practitioner’s experience with the taxing authority. How reasonable have the agents been when faced with the authority that supports the client’s position?
• Since the tax benefit can depend on whether the client is willing to litigate the issue, how willing is the client to fight an adverse determination?
• Consider whether the unit of account initially selected is the most appropriate determination of the tax position. If a higher benefit could be recognized by changing the unit of account (remember the consistency rule though), consider revising what constitutes a unit of account.
• What are the “hazards of litigation” the client faces in the matter?

All of these factors enter into the determination of the tax benefit. While these factors certainly help the client decide what the likely outcome will be, the final determination must be a somewhat subjective conclusion that the recognized tax benefit is the amount that would result after the taxing authority completed the audit or the litigation, whichever is appropriate.

Subtopic 740-10 presents another issue that must be considered. Although Subtopic 740-10 uses the court of last resort as the ultimate determination of whether any tax benefit can be recognized, it also clearly provides that a client, in measuring the amount of the tax benefit, should consider the ultimate tax benefit if the matter were settled. Thus, the tax benefit recognized by a client can also depend on whether the client is willing to litigate the matter through the court of last resort or would likely settle for less tax benefit. If the client concludes that it would likely settle, the tax benefit recognized should be based on the most likely settlement amount.

Example 3. Settlement versus litigation: N Inc. is owned by one shareholder who is also the sole officer. In the current year, N pays the officer $1 million in salary. In preparing the financial statements, N analyzes its risk that some or all of the compensation will be disallowed by the IRS on audit. After careful consideration of the case law and the facts and circumstances, N concludes that the salary deduction meets the MLTN standard. However, N also concludes that the maximum deduction that would be sustained upon litigation is $850,000. Further, N concludes that the IRS Office of Appeals would settle for a salary deduction of no more than $700,000.

If N is willing to litigate the matter, then the tax benefit that can be recognized is $850,000. If N concludes that it does not want to litigate this matter, then the maximum deduction upon settlement will be $700,000, which then becomes the maximum tax benefit recognized.

As Example 3 points out, two companies with identical facts, reaching identical conclusions about the MLTN standard and the measurement of tax benefits, can still recognize different tax benefits, based upon each company’s willingness to litigate the issue, since the most likely outcome will differ in each case. However, a practitioner should make sure that the client understands the cost and risk associated with litigating versus settling the tax issue, and document that understanding to support the conclusion.

Another complexity introduced by Subtopic 740-10 involves computing a deferred tax asset based upon carry­overs. If a tax position does not meet the MLTN test, it clearly cannot be recognized in the financial statements. Further, any carryforward benefit of that deduction cannot be recognized. This will create three possible reporting situations:

1. If the tax position is more likely than not to be 100% sustained, then there will be no difference between the tax return and financial statements, and there will be no unrecognized tax liability.
2. If the tax position is more likely than not to be sustained, but at less than 100%, a corresponding unrecognized tax liability must be created. If the position creates a deferred tax asset, only the portion of the position that is more likely than not to be sustained can be considered in determining the deferred tax asset.
3. If the tax position is not more likely than not to be sustained, the full amount of the tax benefit claimed on the return must be included as an unrecognized tax liability in the financial statements. If the deduction creates a carryover, no deferred tax asset can be created.

It is clear that Subtopic 740-10 requires a substantial amount of professional judgment to determine the appropriate unit of account, the likelihood that the MLTN standard will be met, and the probability of recognizing a tax benefit. In small businesses, the client may not have enough knowledge to determine what uncertain tax positions are, which then places a heavier burden on the practitioner. However, too much practitioner involvement can result in an impairment of independence.  

This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 28th Edition, by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).