THE FASB's GIFT TO THE IRS

Updated January 2007

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In June 2006, the Financial Accounting Standards Board (FASB) issued FIN 48, an amendment to existing standard no. 109, "Accounting for Income Taxes." At first blush, the pronouncement seems simple, fair, and straightforward, but it will have a huge unintended consequence. The pronouncement requires that, starting in 2007, corporations that took aggressive tax positions need to report this to the IRS. The IRS will certainly follow up with a tax bill.

Previously, companies could claim a tax benefit if the deduction is "more likely than not" to ultimately be sustained. Under this language, the tax benefit could be uncertain as long as it had some support. To substantiate the benefit, the tax position needed a greater than 50 percent chance of ultimately occurring. In making the determination that the positions are "more likely than not," a company can currently factor in the possibility that the IRS will not even audit the tax deduction.

FIN 48 simply says that, in order for a company to record a benefit for any tax position, the treatment must have a "probable recognition threshold." Although such items are difficult to measure with precision, this means around a two-thirds or more likelihood that the position would be upheld if subjected to an audit. Under transition rules, previously recorded tax benefits that do not meet the new requirements will be charged against (i.e., reduce) earnings, rather than requiring a restatement of prior periods.

Schedule M on the corporate tax return reconciles book (financial statement) income with taxable income. If there are differences because of different tax treatments, then these differences are shown on Schedule M. Schedule M differences will include the prior period tax benefits that do not meet the current rules - meaning all aggressive current and prior tax positions that remain open under the statute of limitations will be openly reported.

Before, smaller companies had plenty of reason to elect Subchapter S status, in which the corporation reports no income tax expense because the income is reported directly on the tax returns of the shareholders. This election is usually a good idea for companies that can qualify for Subchapter S status. Under such an election, the otherwise double taxation that occurs (i) first at the corporate level, and (ii) secondarily when dividends or distributions are paid to shareholders, is avoided. With the new income tax reporting, qualifying companies have another compelling reason to elect Subchapter S status. Because taxes are eliminated at the corporate level, there is nothing to report in order to comply with the new standard. No disclosures … no red flags to the IRS … and the IRS must earn its keep the same way it has in the past.

Surprisingly, FIN 48 has received little public attention. Yes, we know taxes are boring, but this rule will cost U.S. companies billions of dollars in both charges to earnings and checks written to the IRS.

As taxpayers, perhaps we can all agree that reducing the federal budget deficit is a good idea. The IRS probably never thought it would be so easy to collect additional taxes from larger U.S. companies.

Fulcrum Inquiry is a consulting firm that provides appraisal, claims analysis and forensic accounting services.