And We Thought Taxes Were a Certainty in Life ... Accounting for Uncertainty in Income Taxes

Privately-held companies, including S Corporations, Partnerships, LLCs and not-for-profits, can expect to spend more time preparing their next set of financial statements, and they may find the process more complicated than before.

The reason for the extra work? A new accounting standard for calculating and recording federal and state income tax expense when there’s a chance that the IRS or state taxing authorities would not accept all the tax positions reflected on the company’s income tax returns. Tax positions include deductions or credits claimed and other decisions made (including the decision not to file a return) that impact the return’s bottom line.

You’ll hear the new standard referred to as “FIN 48,” short for the Financial Accounting Standards Board’s new Interpretation No. 48, titled “Accounting for Uncertainty in Income Taxes.” Public companies adopted FIN 48 in 2007. Now it applies to private companies as well — starting with 2009 financial statements.

FIN 48 requires a more rigorous and methodical assessment of financial statement reporting of the tax decisions made by your company. As a result, your management team may have less flexibility in determining tax reserves than in the past.

Private companies most likely have to share their financial statements with lenders and investors -- the new requirements can provide them with more confidence when comparing financial statements by knowing that different businesses use the same criteria when dealing with tax issues.

In any FIN 48 discussion, you’ll hear two terms mentioned often: “uncertain tax position” and “more likely than not” -- which is frequently condensed into the acronym “MLTN.”
To understand how FIN 48 is applied, let’s take an extreme example.

A company has a yacht which it uses to entertain clients. The cost for the crew, fuel, depreciation, meals and other related expenses is $100,000, for which you claim a business deduction. If the company is in a combined federal and state tax bracket of 40%, that means a tax savings of $40,000. If you’re being aggressive in claiming the deduction, chances are the IRS would challenge the expenses you’re trying to write off. This is an example of an “uncertain tax position.”


In pre-FIN 48 days, your accountants might have arbitrarily estimated that half the deduction would be allowed, and set aside $20,000 as a pending tax liability in your financial statement. Or, they might have decided not to worry about it at all. You don’t have that latitude anymore.

So, how do you determine the tax benefit amount to be recognized in your financial statements?

Start with recognition — determining whether it is “more likely than not” that a tax position will be sustained upon examination by the IRS (or state/local authorities for a state or local income tax return). “More likely than not” means a better than 50% chance that your tax position will be sustained, even after appeals and litigation, because of the technical merits of your position, and assuming that taxing authorities have full knowledge of all relevant information related to your claim. In determining whether the “MLTN” threshold is met, you do not factor in your chances of being selected for a tax examination.

If you determine that your tax position doesn’t meet the “MLTN” standard, you’ll have to record the entire tax benefit — $40,000 in our example — as a FIN 48 liability on your financial statement. As a result, the company’s net income will go down by $40,000.

What if your research indicates that the tax position meets the MLTN standard, but not for the full amount? Say there’s only a 5% chance that the full claim would be upheld, a 25% chance that half of the deduction would be allowed, and better than 50-50 chance that only $40,000 of the $100,000 write-off will be upheld? In that situation, you’ve got to record the potential tax liability associated with the $60,000 ($100,000 - $40,000) likely to be deemed taxable, or $24,000 ($60,000 x 40%) in this example, as a FIN 48 liability.

In short, that is how your accounting team must address an “uncertain tax position.” Your situation becomes more complex if you have more than one such position. And, you’ll have to go back more than one year if you have uncertain positions associated with returns that are still open under any statute of limitations, generally three years.

There’s one more daunting prospect involving state and local jurisdictions. If you haven’t filed a return in previous years because you claim you didn’t have to and there’s a chance you might be liable — well, FIN 48 guidelines consider that an “uncertain tax position” that has to be evaluated under the FIN 48 standard. In this situation, the company could be liable for payments for all years in which it should have filed state income tax returns.

What will this mean? Studies of public companies have shown substantially more companies have had to report increases rather than decreases in tax liabilities, though the increased liability is usually less than 50% of what was previously recorded. About one company in five reported no significant impact on their financial statements.

It’s reasonable to assume outcomes for private companies will be similar, but right now plan to spend some extra time reviewing tax liability issues with your accounting team as part of the preparation of your next annual financial statements.

By ANDY PATTERSON, CPA
Andy Patterson, CPA, is a director of Horty & Horty, P.A.,
a Delaware accounting firm with offices in Dover and Wilmington.