FASB Accounting Standards Codification (ASC) Subtopic 740-10 (which incorporates most of former FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes), requires that each tax position meet a more-likely-than-not (MLTN) test and that the tax benefits be correspondingly reduced if the result is not certain. In essence, the reporting requirements provide a glimpse into how much tax risk a company is prepared to take.
Subtopic 740-10 applies to GAAP-basis financial statements, be they audited, reviewed, or compiled financial statements. Accordingly, Subtopic 740-10 will not apply to cash-basis financial statements or to any other non-GAAP-basis statements. Subtopic 740-10 deals with all income tax positions; by definition, it does not apply to sales, use, property, intangible, or value-added taxes. It applies to any income tax in any jurisdiction, whether it is federal, state, local, or foreign income tax, and it applies to any entity that might be subject to income tax.
Subtopic 740-10 offers a seemingly simple process:
- Inventory all tax positions for all open years, including the current year, for all jurisdictions;
- Classify all tax positions as uncertain or routine business transactions meeting the MLTN standard; and
- Determine whether the tax benefits from uncertain tax positions (and how much of those benefits) should be reported in the financial statements.
Observation: Clients should continue to assess the impact of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, and any related regulations on their material tax positions and apply the process outlined above to document and assess any new uncertain tax positions.
While labeled a "simple process," the client must exercise a great deal of judgment in reaching conclusions in each of these areas. Also, since Subtopic 740-10 requires a review of all open years for all jurisdictions, clients must reassess and quantify the consequences of decisions not to file returns or to take aggressive positions made years ago. Although Subtopic 740-10 does not specifically address the issue, it seems logical to conclude that a decision involving an uncertain tax position that potentially omitted more than 25% of gross income would require the application of the six-year statute of limitation rather than the typical three-year statute of limitation. Additionally, it also is logical to conclude that there may be an indefinite deferral of any tax benefits, plus penalty and interest issues, if required tax returns are not filed.
The administrative issues and problems created by this requirement can be significant. Subtopic 740-10 provides no safe harbor to deal with these issues, other than the ability to disregard "immaterial" amounts. Clients must be made aware of the effort this will likely take the first year that Subtopic 740-10 is implemented, since all open years must be scrutinized for uncertain tax positions and the recognition of potential tax liability.Inventorying tax positions
The first step is to inventory all of the client's tax positions. This means conducting a thorough review of the tax returns for each open year to identify material tax positions. It also means that any decision not to file or how to allocate income must be reviewed. The initial requirement to inventory really means that the client must assess each material tax position taken on any income tax return for any open year. Thereafter, each tax position taken in the current year must be inventoried, and prior open issues must be reassessed.
A tax position is any determination of tax treatment in a filed return or a return to be filed that is reflected in the measurement of deferred tax assets or liabilities in any financial statement, including interim financial statements. This is a broad definition that includes permanent tax reductions and positions that merely defer tax liabilities, as well as a change in the anticipated recognition of tax obligations. A tax position also encompasses a decision to file or not file a return, interjurisdiction income allocations (between states, or the United States and foreign countries), and determinations of whether income is taxable or tax-exempt.
For many privately held companies, the most troubling issues are those involving aggressive tax planning in prior years. Since there was no requirement to disclose any of those positions in the tax return, they were invisible to both the IRS and readers of the financial statements. Now, however, Subtopic 740-10 requires disclosure of those positions as well as a statement of their impact on the financial statements.
Once all of the material tax positions have been inventoried, the provisions of Subtopic 740-10 can be applied. However, FASB did not intend for Subtopic 740-10 to have a significant effect on routine, day-to-day business tax transactions that would clearly meet the MLTN requirement and be fully allowed on audit. Thus, for example, the normal operating costs of a business would fall outside Subtopic 740-10's scope.
Example. Normal business transactions create full tax benefits: H Sales Inc. sells a variety of products for various manufacturers. H properly deducts all sales expenses as they are incurred, including commissions earned as sales are made. It also deducts office salaries, supplies, and utilities. Since each of these expenses represents a day-to-day transaction that more likely than not will be fully sustained on audit, Subtopic 740-10 should have no impact on these tax issues.
The second step in inventorying tax positions is to determine what the appropriate unit of account is. While selecting a unit of account might initially seem almost mechanical, it requires a great deal of professional judgment, since all determinations required by Subtopic 740-10 are driven off the selection of a unit of account. Unfortunately, Subtopic 740-10 does not define or provide clear guidelines about how to determine what a unit of account is, requiring client judgment in analyzing a particular business's facts and circumstances.
What is clear is that aggregating tax positions for one or more similar items on the return is an option. However, when the total tax position comprises multiple items, it may also be possible to use a separate determination for each component part rather than the aggregate. The choice of which unit of account to use must be based on the facts and circumstances of each case. Clearly, a smaller unit of account may make it easier to meet the MLTN test, whereas an aggregate tax position with many component parts may have difficulty meeting the MLTN test. Whichever option is used, it should be consistently applied for each period, unless a change in the facts and circumstances justifies a change in the unit of account.
- Whether the units are treated separately on the client's books and records;
- How easy it is to identify and segregate the smaller units;
- How the taxing authority would audit the transaction — i.e., would the IRS treat the transaction as one transaction or consider the component parts;
- The complexity of the transaction;
- The interdependence among the component units; and
- How the units are treated for other purposes — i.e., separate contracts, different managers, etc.
Observation:ASC Paragraph 740-10-25-13 states the "appropriate unit of account for determining what constitutes an individual tax position . . . is a matter of judgment based on the individual facts and circumstances of that position evaluated in light of all available evidence." Therefore, the entity should use its judgment in selecting the appropriate unit of account for a tax position. The unit of account should be consistently applied to similar positions from period to period unless a change in facts and circumstances indicates that a different unit of account is more appropriate.Classifying tax positions as uncertain or routine transactions
Subtopic 740-10 distinguishes between routine business transactions that are clearly more likely than not to be fully sustained on audit and those tax positions that have either factual or legal uncertainty. A business's normal operating expenses, such as clerical salaries, utilities, office supplies, and any number of other daily, routine income and expenses should not, as a practical matter, be affected by Subtopic 740-10. Accordingly, most small businesses should be able to classify the vast majority of their issues as routine business transactions.
Since the goal of Subtopic 740-10 is really to identify risky tax positions and attempt to reasonably quantify the tax benefits from those positions, routine or highly certain tax positions present little problem. In fact, for a closely held company, these types of tax issues should be predominant in the financial statements. Where a position is highly certain, little documentation seems warranted.
In determining whether a tax position is a routine business transaction or an uncertain tax position, both the technical rules as well as administrative practice can be considered. If, for example, the client expenses all capital purchases costing less than $10,000, it is clear that there has been a technical violation of the tax rules. If the threshold is $5,000, the client has an applicable financial statement, and the client meets the other requirements of Regs. Sec. 1.263(a)-1(f)(1), the full tax benefit presumably could be recognized.
The use of administrative practices to support a tax benefit deals only with limited technical tax law violations that are commonly ignored by a taxing authority. Using administrative practice as support for a tax benefit means the matter is widely prevalent and is understood to be so by tax practitioners. The administrative practices concept cannot be used where significant professional judgment is required or where the interpretation of a substantial tax position is required.
Further, the administrative practice rule generally cannot be used where the client is required to self-report a tax violation (e.g., amnesty) but fails to do so. In that case, the question is whether the administrative practice would be to ignore the violation, even though it is not self-reported. If the violation would still be ignored, then the client can use the administrative practice as support for the tax benefit. If the violation would not be ignored unless it were self-reported, no tax benefits can be considered under the administrative practices exception.
Perhaps the biggest advantage to using administrative practices to avoid a Subtopic 740-10 unrecognized tax benefit arises in the state tax context. Obviously, a failure to file an income tax return with a state creates a potential tax liability. On the other hand, it also reduces the income tax liability for the state, since the income is reported in the home state. Thus, in most cases, the failure to allocate and report income to various states may be a net zero-sum event, or at least arguably immaterial.
The problem that a nonfiler has, however, is that the statute of limitation does not begin to run until a complete return is filed. Thus, a taxpayer could have a large number of open years with tax liabilities for one state, while the statute on claiming a refund from a state where a return has been filed is generally limited to three years. If the state for which a return must be filed has an administrative practice limiting recovery of income taxes to four or five years, the net difference may be immaterial, eliminating the need to disclose any Subtopic 740-10 adjustment.
Clients should clearly understand that the purpose of identifying, classifying, and measuring uncertain tax positions is to provide a realistic idea of what the ultimate income tax consequences are of a particular transaction, based upon solid professional judgment. This requires putting each tax decision to the test of whether, in the client's judgment, the tax benefits flowing from the transaction will really be realized. In short, Subtopic 740-10 requires clients to determine what the likely results of an audit will be long before any taxing authority has even considered auditing the client. This, in turn, can create a conflict between the practitioner and the client as to whether the MLTN test is met and, if it is, what tax benefit can be recognized.
This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations, 32d Edition (March 2019), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2019 (800-431-9025; tax.thomsonreuters.com).