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Friday, January 7, 2011

IRS Regulation: Corporate Disclosure of Uncertain Tax Positions

The IRS recently issued a final regulation that marks the culmination of its efforts to require certain corporations to submit information related to uncertain tax positions along with their income tax returns, beginning with 2010 returns. The new requirements represent a significant shift in the extent of information corporations filing Forms 1120, 1120-F, 1120-L or 1120-PC must disclose to the IRS.

S corporations are exempt from this new IRS requirement even though reserves for uncertain tax positions may be reflected on their financial statements.

Uncertain Tax Positions: A Brief History
Financial statements issued in conformity with Generally Accepted Accounting Principles (GAAP) already require corporations to identify and quantify the potential income tax liability resulting from all uncertain tax positions, as described by the Financial Accounting Standards Board in Accounting Standards Codification Topic 740, Income Taxes, Subtopic 740-10 (more commonly known as FIN 48). A tax position isn’t considered “uncertain” if it’s “more likely than not” (defined as a more than 50% likelihood of success) that the position will be upheld on examination by the IRS.

GAAP generally requires a corporation to establish a reserve for uncertain tax positions, but reserves aren’t required for uncertain tax positions 1) that the corporation expects to litigate or 2) for which the corporation has determined that the IRS has a general administrative practice of not examining in audits.

FIN 48 has been of limited value to the IRS, however, because it generally requires consideration of all tax positions taken (or not taken) on every tax return filed (or not filed) in every jurisdiction imposing an income tax. In addition, it requires disclosure of only aggregate amounts as opposed to disclosure of itemized details about specific uncertain tax positions and jurisdictions. So if the IRS wanted to identify uncertain tax positions, it had to select a return for audit and, according to the agency, expend a great deal of effort to determine which uncertain tax positions might relate to the return.

In January 2010, the IRS announced its plan to begin collecting information on uncertain tax positions in order to make its audit process more efficient. In April, the IRS released a proposal that would require corporate taxpayers to report information on their uncertain tax positions with their tax returns, along with a draft form (Schedule UTP) and instructions, for public comment. In September, it issued a proposed regulation and a finalized schedule and instructions.

Key Provisions and Changes
The final regulations made several changes to the proposed requirements for reporting uncertain tax positions. Here’s an overview:

Who must report and when. There is a five-year phase-in of the reporting requirement, based on corporations’ asset size. Corporations that issue audited financial statements (or have a related party issuing such statements) and that have $100 million or more in assets must file Schedule UTP beginning with the 2010 tax year — if they have one or more tax positions that must be reported. In 2012, the asset threshold is scheduled to fall to $50 million. Corporations with $10 million or more in assets must begin reporting in 2014 under current rules.

This phase-in is good news for smaller corporations because the draft schedule and instructions applied the $10 million threshold beginning with the 2010 tax year.

Description of uncertain tax positions. The final instructions require a corporation to disclose only sufficient information to identify the issue and the relevant facts, stating outright that a corporation isn’t required to include an assessment of the hazards of a tax position or an analysis of the support for or against the position. The IRS anticipates that in most cases the description need not exceed a few sentences.

The IRS initially planned to require corporations to report the rationale for uncertain tax positions and the nature of the uncertainty — disclosures that aren’t required under GAAP and that opponents have argued would provide a roadmap for IRS audits.

Reporting of uncertain tax positions with reserves. The instructions require taxpayers to rank their uncertain tax positions from highest to lowest based on the size of their reserve amounts, but taxpayers won’t need to disclose the reserve amounts. Taxpayers must also designate any positions for which the reserve exceeds 10% of the total reserves.

The original proposal would have been more burdensome and perhaps riskier for taxpayers. It directed Schedule UTP filers to calculate a maximum tax adjustment (MTA) for every tax position on the schedule. Commenters complained that this would be unduly burdensome and could provide the IRS with a distorted view of a position’s riskiness. In response, the IRS dropped the MTA requirement.

Reporting of uncertain tax positions without reserves. Disclosure is also required for uncertain tax positions that the company expects to litigate, even though GAAP doesn’t require reserves to be maintained for such positions. Taxpayers aren’t, however, required to report a tax position that it would litigate if challenged but that is clear and unambiguous or immaterial.

The IRS originally also sought the disclosure of positions that didn’t require reserves due to IRS administrative practices, but it ultimately eliminated that requirement.

The Effect on Attorney-Client Privilege
The IRS’s pursuit of information on uncertain tax positions, through the new regulatory scheme and in individual audits in the past, has raised concerns that adversaries (including the IRS) could argue that a corporation has waived protections for confidential communications, such as tax reconciliation workpapers, related to disclosed tax positions.

The IRS has pledged not to seek documents in the course of an audit that would be otherwise privileged, even when a corporation has disclosed the documents to an independent auditor as part of a financial statement audit. It will also allow corporations to redact certain information in workpapers that they’re required to produce during an IRS audit.

What Now?
The good news is that corporations don’t need to report uncertain tax positions taken before 2010, even if they record a reserve in audited financial statements issued in 2010 or later. It’s also not necessary to file a Schedule UTP for short tax years ending in 2010. Please contact us to determine what and when you need to report.


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