Many businesses have taken positions on their tax returns that could one day be challenged by the Internal Revenue Service. If the IRS successfully challenged one of those tax positions, the business may owe back taxes. Until recently, many companies ignored this potential tax liability on their financial statements, even though the amounts involved could be substantial. Recent changes in accounting standards now require companies to measure and recognize those potential tax determinations in their financial statements.
Business owners, accountants, auditors, and tax advisors are now grappling with how to implement these new rules found in the Financial Accounting Standards Board’s Interpretation No. 48 (also known as “FIN 48”).
Previously, Financial Accounting Standard Statement No. 109, “Accounting for Income Taxes” (“SFAS No. 109”), provided little guidance on how to account for uncertain income tax positions. As a result, companies have adopted various accounting practices to determine whether and to what extent tax return benefits should be treated in their financial statements. Therefore, FIN 48 was issued to provide consistent accounting practices for estimating and reporting potential assessments due to these “uncertain” tax positions.
FIN 48 applies to businesses, nonprofit organizations, partnerships and other pass-through entities, real estate investment trusts, and registered investment companies that issue financial statements based on generally accepted accounting principles (GAAP).
Covers all income tax positions, such as favorable positions taken in so-called “gray areas” on previously filed income tax returns (for years that are still open). The Interpretation also covers positions expected to be taken in an upcoming tax return that are reflected in the measurement of current or deferred income tax assets and liabilities.
FIN 48 also covers possible assessments associated with tax returns not yet filed (such as failure to file a return in a state where the business has a nexus).
FIN 48 became effective for fiscal years beginning after December 15, 2006 for publicly traded companies. For all other entities, FIN 48 is effective for quarterly and annual financial statements for fiscal years beginning after December 15, 2008. For example, a quarterly statement issued by a private company as of March 31, 2009 may need to reflect a possible previously unaccounted-for tax liability.
Assessing a tax position under FIN 48 is a two-step process. First, determine whether the tax position is “more likely than not” to hold up after examination by a tax authority that has full knowledge of all relevant information. If it is very likely to sustain, then no liability would need to be accounted for. But, if the tax status was contested by a tax authority and you decided to negotiate a settlement, a liability for the difference in tax benefit may need to be recorded. However, if it is very likely that the tax position will not be sustained, the largest amount of tax that is more than 50% likely to be due at settlement with a taxing authority should be recorded in the financial statements.
This could result in an increase in a current income tax liability or perhaps reduce a receivable income tax refund, as well as reduce a deferred tax asset or increase a deferred tax liability, or both.
The Interpretation requires certain disclosures. At the end of each annual reporting period, the financial statements must disclose the total amount of unrecognized tax benefits, the total amounts of possible interest and penalties recognized in the income statement, and a description of the fiscal years. that are subject to examination by tax authorities.
At subsequent financial reporting dates, the company is required to review the circumstances and information available as of that reporting date to determine whether there is a need to reassess the previously recognized tax benefit. Any change to the previously reserved amount must be based on new information rather than a new evaluation of previous information. A new tax court ruling or change in IRS regulations could cause a change in the amount of tax benefit recognized or may cause an uncertain tax position to cross the “more likely than not” threshold. In reassessing its tax position, a company may determine that it has sufficient information to recognize, write off, or subsequently measure an uncertain tax position.
FIN 48 has several important implications that financial statement preparers should consider. Implementation of these new rules will require considerable judgment, as well as an understanding of the tax positions taken on all federal and state tax returns, including unfiled tax returns. For example, accountants must be able to justify why a tax return may recognize a benefit from a tax deduction, while the related financial statements do not reflect that benefit because the position taken does not meet the new “most likely not.” “threshold for FIN 48. The company’s accountants, auditors and tax advisors must coordinate the implementation of FIN 48.
As of now, it remains unclear how closely IRS auditors will focus on work developed to support FIN 48 considerations.