ASC Topic 740 and state taxes continue to require due diligence

Editor: Mo Bell-Jacobs, J.D.

Accounting for income taxes in accordance with FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes, is a time-consuming and complex process. Federal and state tax laws are constantly changing and, as businesses evolve, it is important for taxpayers to carefully review business operations and state tax laws to account for state income taxes in their financial statements. This overview illustrates key concepts for finance departments to consider in preparing the state tax provision.

Business activity and nexus considerations

When taxpayers compute the state income tax provision, one of their first and most important considerations is determining where they have a state income tax filing requirement. ASC Topic 740 requires taxpayers to account for income taxes in each jurisdiction in which they are subject to tax. For multistate taxpayers, this can be a daunting task. Many businesses have expanded footprints from increased internet activity that allows companies to reach customers everywhere. In response, state legislatures and taxing authorities continue efforts to expand income tax nexus principles. In the wake of South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018), which paved the way for economic sales tax nexus provisions, many states also adopted new bright-line receipts thresholds for income tax nexus. As a result, taxpayers must analyze their business activity based not only on their physical footprint but in each jurisdiction where the company may be engaging in economic activity.

Taxpayers that derive revenue from the sale of tangible personal property have long enjoyed federal protection from state income tax nexus under the Interstate Income Act of 1959, better known as P.L. 86-272, to the extent that the activity in the state is limited to the solicitation of sales of tangible personal property that are approved and shipped from outside the state. P.L. 86-272 also provides a list of ancillary activities that are protected or unprotected. Enacted in 1959, P.L. 86-272 does not address any internet activities.

On Aug. 4, 2021, the Multistate Tax Commission (MTC) adopted a new interpretation of P.L. 86-272 identifying unprotected internet activities, significantly chipping away at the scope of the statute’s protection from state taxation (see DeBruin and Smith, “Consequences of the MTC’s New Interpretation of P.L. 86-272,” 54-5 The Tax Adviser 17 (May 2023)). States are now seeking to adopt the revised MTC guidance, including New York, which finalized regulations on Dec. 27, 2023, related to the comprehensive franchise tax reform of 2014, that adopt the revised MTC guidance. California made a similar attempt, but it was struck down by a California superior court on procedural grounds (American Catalog Mailers Ass’n v. Franchise Tax Board, No. CGC-22-601363 (Cal. Sup. Ct., San Francisco County, 12/13/23)). It remains uncertain how the Franchise Tax Board will proceed but, clearly, state taxing authorities intend to assert income tax nexus more broadly on sellers of tangible personal property.

As noted above, many states have implemented bright-line nexus thresholds. As a result, it is more important than ever to determine how each state would source a taxpayer’s receipts. The application of sales-factor sourcing rules varies widely among the states, depending not only on whether the state applies a market-based sourcing or a cost-of-performance approach but also the nature of the receipts. For example, a taxpayer providing services to business customers may be required to “look through” the location of the business customer to the ultimate recipient of the services, who may be located in another state. Further, there may even be industry-specific sourcing and apportionment factor rules that apply. Even with taxpayers’ best efforts, the application of state laws can be an area of great uncertainty for businesses in preparing state income tax provisions.

Uncertain tax positions

ASC Topic 740 recognizes that there will be uncertainty in evaluating nexus, sourcing, and other issues and provides a mechanism for accounting for uncertain tax positions (UTPs). Taxpayers may take the position that they are not required to file a tax return in a particular state, but to recognize the benefit of a nonfiling position, the taxpayer must demonstrate that it is more likely than not (greater than 50% chance) that the taxing authority would sustain the tax position based solely on the technical merits. If this recognition threshold is not met, the taxpayer must recognize a liability for the entire UTP, including interest and penalties. Tax positions that meet the more-likely-than-not threshold for recognition are measured as the largest amount of tax benefit that is more than 50% likely to be realized upon ultimate settlement with the related tax authority. Any difference in measurement from the full amount of the tax benefit is recorded as a UTP.

Current versus deferred rates

Some taxpayers may use the same effective state tax rate for both the current and deferred state tax provisions. However, ASC Topic 740 requires that deferred taxes be measured at the effective tax rate for the period in which the deferred tax asset or liability is expected to reverse. The appropriate deferred tax rate considers changes to apportionment due to enacted legislation that will be in effect in a future period or due to reasonably estimated changes in business operations. The deferred tax rate also accounts for enacted statutory rate changes that will be in effect in future years. Depending on the nature of the deferred tax asset or liability, this may be the tax year immediately following the current period or a tax period projected well into the future. Taxpayers should evaluate the state rules in future periods in calculating the deferred state tax provision.

State conformity to various federal provisions

In accounting for state income taxes, taxpayers are required to account for state differences in federal conformity, whether permanent or temporary. Prior to the 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, the most significant state modifications generally were the state tax deduction, bonus depreciation, and items of foreign income such as those under Subpart F and the Sec. 78 gross-up. The TCJA brought significant changes to the Code such as limitations on the deductibility of business interest expense under Sec. 163(j) and the requirement to capitalize and amortize research and experimental expenses under Sec. 174. Additionally, the TCJA created the concepts of global intangible low-taxed income (GILTI) and foreign-derived intangible income (FDII) and limited the use of net operating losses (NOLs) to 80% of federal taxable income for NOLs generated after Dec. 31, 2017 (suspended for tax years beginning prior to Jan. 1, 2021). States vary widely as to how they conform to these provisions of the TCJA and continue to update their conformity to the IRC either on a rolling basis, as of a fixed date, or on a selective basis.

For taxpayers with multiple entities, it is important to consider the appropriate filing methodology among the state jurisdictions (separate, mandatory combined unitary, worldwide, etc.) and how that affects the calculation of state modifications. For example, while a taxpayer may not be subject to Sec. 163(j) limitations on a federal consolidated basis, the taxpayer may be required to file on a separate-state basis in jurisdictions that conform to Sec. 163(j). In that case, the taxpayer is required to calculate any Sec. 163(j) limitation on a separate pro forma basis to determine whether a business interest expense limitation exists for state-only purposes. As a temporary difference, this will create a deferred tax asset that must be tracked separately for different states and different filers within a combined group. This is but one example of the many nuances involved in calculating state modifications for provision purposes.

Planning for additional income tax disclosures

Many companies, too, will be affected by the additional disclosure requirements under Accounting Standards Update (ASU) No. 2023-09, Improvements to Income Tax Disclosures, which FASB issued in December 2023. The intent is to increase transparency by disaggregating income taxes by jurisdiction so that investors can understand how tax strategies or risks may affect the financial health of a company. The disclosure requirements are effective for annual tax periods beginning after Dec. 15, 2024, for public business entities and for periods beginning after Dec. 15, 2025, for all other entities. Taxpayers may adopt the guidance of ASU 2023-09 prior to the effective dates.

ASC Topic 740 requires a taxpayer to account for income taxes in each jurisdiction in which the taxpayer is subject to tax. However, in practice, many taxpayers use a blended state rate, which may be appropriate depending on the fact pattern. Under ASU 2023-09, entities will be required to provide qualitative disclosures as to which states contribute to the majority (greater than 50%) of state and local income taxes. This new disclosure requirement likely will create additional work for taxpayers needing to provide more detailed information for financial reporting purposes.

Tax accounting expertise needed

As businesses evolve, new tax laws are adopted, and additional guidance is provided by taxing authorities, it is critical for business to ensure they have the right expertise needed to properly account for state income taxes in their financial statements. Consultation with state tax professionals is highly recommended.

Editor Notes

Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP.

For additional information about these items, contact the author(s) of this item: Amy Letourneau, J.D., Washington, D.C..

Contributors are members of or associated with RSM US LLP.