A little less than a year ago, the Financial Accounting Standards Board (FASB) issued an interpretation (FIN 48) dealing with the reporting of income taxes. The initial response to this news for many business owners was “so what”? The average person probably wouldn’t argue with that, but CPAs take a different view of FIN 48. The reality is that FIN 48 will affect any company that presents its financial statements using generally accepted accounting principles (GAAP).
FIN 48 is titled Accounting for Uncertainty in Income Taxes and, in some ways, actually creates more uncertainty than ever. It is now in effect for calendar year taxpayers – and, for fiscal year taxpayers, kicks in when their 2007-2008 year begins.
As its name implies, FIN 48 is intended to eliminate the perceived differences in the way companies treat the effects of various tax strategies. A prime motivator is to curtail the use of a company’s income tax reserve as a means to smooth out earnings. If your company does business in only one county in one state in the United States, and there is no question about the components of your taxable income, this is a reasonable requirement. However, if your company does business in various jurisdictions in multiple states - or internationally - you are in for some extra work when the time comes to prepare your 2007 financial statements.
Companies that have operations in various states will have some of the following problems:
- Determination of the proper allocation of income to each state;
- Determination of the character of income as business or non-business income;
- Determination of filing requirements by state, including the decision whether to file or not (i.e. does the company have nexus?);
- Determination in some states whether taxable income should be reported on a separate company or unitary basis;
- Various other nuances applicable to specific states.
Perhaps the most troublesome requirement will be for companies to describe the effects of not filing income tax returns in states where it may be taxable. This can occur whenever a company has nexus in a state other than where it is headquartered. Simply put, nexus is a business’ connection to a state sufficient to allow the state to tax that business. In some states, simply selling goods or services inside the state might constitute nexus, while others might require that you have an employee living in the state. Having property in a state is also a factor - if you don’t have an employee located there, don’t assume that you are off the hook. In some states, if a salesman travels into the state to solicit orders, or you hire a contractor to perform a service, you may have nexus.
If you look at the preceding paragraph, it looks as if there are rules you can follow to determine if your business should file a tax return in a particular state. Yes, there are rules – very complicated rules – to determine if your company has nexus, but following the rules on the books does not always yield the answer a state’s department of revenue would give. For example, a company undertook a study to determine if it was taxable in each of the states where it did business. Among those states were Florida and Oklahoma. The study’s conclusion was that the company was taxable in these two states. However, when these states eventually contacted the company and were given the facts, they determined the company had no nexus in either state.
Suppose a company determines it is taxable in New Mexico, but decides to play the odds and wait until the State forces it to file. What happens then? Prior to FIN 48, the income tax provision probably did not include taxes for New Mexico. Now, even if you choose not to file the return, you must disclose the fact that a liability to the State exists and record the amount in your financial statements. You must also include the liability in the provision and calculate and record interest and penalties on the unpaid tax. Thus, if you are audited by a state in which you do pay tax, and that state has a reciprocal deal with New Mexico, the auditor may inform New Mexico of the unpaid tax. As a practical matter, your net income after taxes will also be decreased.
As significant as unpaid state taxes may be, Federal taxes are generally higher. FIN 48 will force taxpayers to disclose significant uncertainties in their tax provision. This can be disastrous if a company has taken a legitimate position on its tax return that is subject to challenge. The IRS has announced that it will consider auditors’ and accountants’ work papers as if they were client-prepared documents and subject to review in an audit. Previously, an auditor’s tax provision work papers were examined only if tax shelters were involved.
Can you imagine what a great road map these work papers could be to a revenue agent? First, the agent will have the GAAP basis financial statements to review for possible issues. Then, the agent will be able to look at supporting documents that will further describe tax strategies that might be disallowed. What a great tool!
So what can you do about this new threat to your company? First, if you are not audited or reviewed, and the bank doesn’t require a full disclosure GAAP financial statement, prepare only a compilation with no disclosures. Second, if you are required to prepare financial statements that are ‘full disclosure’ (audited, reviewed or compiled), ask your creditors if they will accept statements prepared on the income tax basis or other comprehensive basis of accounting (OCBOA). You may be able to present the financials using OCBOA and avoid the application of FIN 48.
The preparation of financial statements and income tax returns is difficult and time consuming. Included in the process is the exercise of considerable judgment as to the characterization and taxability of income. The issuance of FIN 48, while well intended, will add greater complexity and uncertainty to many tax provisions for GAAP basis financial statements. If you think FIN 48 might apply to you, give us a call. We can look at your tax picture and guide you through the rough waters of FIN 48. Together, perhaps we can minimize the IRS’ ability to use this new tool against you.
Have a great independence day.