An Update on Accounting for Uncertainty in Income Taxes

FASB implementation guidance addresses pass-through entities and tax-exempt not-for-profit organizations.

Preparers of private company and not-for-profit organization financial statements will have to implement provisions of Topic 740 of the FASB Accounting Standards Codification (ASC) relating to accounting for uncertainty in income taxes (formerly FASB Interpretation no. 48, commonly known as FIN 48) for annual financial statements for periods beginning after Dec. 15, 2008. This article addresses some considerations in implementing Topic 740 relating to accounting for uncertainty in income taxes, with an emphasis on pass-through entities and tax-exempt not-for-profit organizations.


FIN 48 was effective for fiscal years beginning after Dec. 15, 2006, and included pass-through entities and tax-exempt not-for- profit organizations within its scope, even though these types of entities are not typically subject to income taxes. As a result, many questions arose about how pass-through entities and tax-exempt not-for-profit organizations were to apply this standard. FIN 48 did not provide any relevant examples.


In September 2007, after conducting outreach to its constituents, the Private Company Financial Reporting Committee (PCFRC) recommended that FASB defer FIN 48’s effective date for nonpublic entities until clarification and guidance were issued on its implications for pass-through entities. In addition, the PCFRC asked the board to consider the usefulness of FIN 48’s disclosure requirements for private companies. In May 2008, after further outreach to preparers and users of private company financial statements, the PCFRC recommended that FASB exempt private companies from FIN 48. In response, FASB convened a “user panel” in August 2008 consisting of bank lending officers, sureties and venture capitalists. The board declined to exempt private companies and not-for-profit entities from FIN 48. However, as a result of the input from the user panel, the board decided to modify the disclosure requirements for nonpublic entities. Accounting Standards Update (ASU) 2009-06, issued Sept. 2, 2009, modified the ASC to provide the needed guidance and eliminate certain disclosures for nonpublic entities relating to unrecognized tax benefits.


Topic 740 prescribes how to account for uncertainty in income tax positions taken or expected to be taken in a tax return. Evaluating a tax position is a two-step process. An entity first determines whether it is “more likely than not” (MLTN) that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The entity must assume that the position will be examined and that the taxing authority will have full knowledge of all relevant information. The second step is measurement. A tax position that meets the MLTN recognition threshold shall initially and subsequently be measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. ASC paragraph 740-10-55-103 provides an example. The differences between the tax benefits taken in the tax return and the amounts recognized in the financial statements will generally result in one of the following:

a. An increase in a liability for income taxes payable or a reduction in an income tax refund receivable

b. A reduction in a deferred tax asset or an increase in a deferred tax liability

c. Both a and b


Private companies that are not pass-through entities or that file returns in states where they are not pass-through entities have long been subject to the standards for accounting for income taxes. Prior to the issuance of FIN 48, income tax standards contained no specific guidance on how to account for uncertainties in income taxes. Many entities used a valuation allowance to adjust income tax assets for uncertainties. Some entities provided a “reserve” included with income tax liabilities for possible audit adjustments. Topic 740 requires an affirmative evaluation of whether it is MLTN (greater than a 50% chance) that the entity is entitled to an economic benefit resulting from tax positions taken in income tax returns.


Treasury Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, Enrolled Retirement Plan Agents, and Appraisers before the Internal Revenue Service (revised April 2008), paragraph 10.34, Standards for Advising With Respect to Tax Return Positions and for Preparing or Signing Returns, holds a preparer to the realistic- possibility standard. It states:


“A position is considered to have a realistic possibility of being sustained on its merits if a reasonable and well informed analysis of the law and the facts by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits. … The possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be settled may not be taken into account.”


Because practitioners have had to work within the requirements of Circular 230, they should be used to analyzing tax positions from the perspective of sustainability. However, when preparing GAAP financial statements, CPAs will still need to consider the requirements of Topic 740, because all tax positions are subject to the more stringent (greater than 50%) recognition and measurement principles of Topic 740.


ASU 2009-06 modified the Codification to clarify that all entities are subject to Topic 740, even if the only tax position in question is the entity’s status. For pass-though entities and tax-exempt not-for-profit organizations, the first step in implementing Topic 740 is to determine if it is MLTN that the pass-through or tax-exempt status would be sustained upon audit. For example, management must determine whether an S corporation has done anything that would jeopardize its S election, such as adding shareholders beyond the maximum number allowed. The next step would be to determine if there are other tax positions to consider, such as the calculation of the built-in gains tax for an S corporation, or the recognition of unrelated business income for a tax-exempt not-for-profit organization.


ASU 2009-06 does not amend the Codification to provide additional guidance on defining an income tax. This term is already defined in the Topic 740 glossary. However, many believe that more guidance is needed in this area because many jurisdictions have imposed taxes that are based on both income and other factors.


ASU 2009-06 modifies the Codification to provide guidance for pass-through entities and tax-exempt not-for-profit organizations in three areas:

a. Definition of a tax position

b. Attribution of income taxes to the entity or its owners

c. Financial statements of a group of related entities


A tax position is defined in the glossary of the Codification as “a position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods.” The definition goes on to state that “the term tax position also encompasses but is not limited to:

a. A decision not to file a tax return

b. An allocation or a shift of income between jurisdictions

c. The characterization of income or a decision to exclude reporting taxable income in a tax return

d. A decision to classify a transaction, entity or other position in a tax return as tax exempt

e. An entity’s status, including its status as a pass-through entity or a tax-exempt not-for-profit entity.”

In implementing Topic 740 an entity must apply the criteria to each jurisdiction in which it is subject to income tax. Applying the criteria to jurisdictions where tax returns are filed is fairly straightforward. However, one area where Topic 740 implementation could be problematic is that of nexus in jurisdictions where an entity may be subject to income tax but has never filed a tax return. States and municipalities have become more aggressive in seeking revenue. Under Topic 740, an entity must assume that a tax position will be examined. In many jurisdictions there is no statute of limitations for a failure to file a tax return. Guidance in Topic 740 suggests that the entity would look to the tax authority’s past administrative practices and precedents in determining how far back the entity must go to assess an uncertain tax position.


As a result of implementing Topic 740 relating to accounting for uncertainty in income taxes, some entities may decide that when it is MLTN that they have to file a return in a jurisdiction, it is easier to file than to recognize a potential liability (plus penalty and interest) that may never reverse. Bear in mind that, as with all FASB standards, Topic 740 need not be applied to immaterial amounts.



The guidance in Topic 740 states that if the taxing jurisdiction’s laws and regulations attribute income taxes to the entity, amounts due to or from the taxing jurisdiction shall be classified as income taxes, and all the provisions of Topic 740 must be applied to those income taxes. If the taxing jurisdiction’s laws and regulations attribute income tax to the owners, amounts due to or from the taxing jurisdiction shall be classified as a transaction with owners.


Paragraphs 740-10-55-223 through 740-10-55-229 provide several examples, one of which is: “Entity A, a partnership with two partners … has nexus in Jurisdiction J. Jurisdiction J assesses an income tax on Entity A and allows [the partners] to file a tax return and use their pro rata share of Entity A’s income tax payment as a credit (that is, payment against the tax liability of the owners). Because the owners may file a tax return and utilize Entity A’s payment as a payment against their personal income tax, the income tax would be attributed to the owners by Jurisdiction J’s laws whether or not the owners file an income tax return. Because the income tax has been attributed to the owners, payments to Jurisdiction J for income taxes should be treated as a transaction with the owners” (paragraph 740-10-55-226, as amended by ASU 2009-06).


To consider tax uncertainties surrounding Jurisdiction J in this example, the preparers would first consider if it were MLTN that the pass-through status would be sustained upon examination by Jurisdiction J for all positions taken. If yes, then no further consideration would be necessary, since the income tax—or any future income tax assessment as a result of an audit—is attributable to the partners. The entity’s tax status should be reviewed annually to be sure that the pass-through status has not changed.



The basic principle relating to financial statements of a related group of entities is that regardless of the tax status of the reporting entity, the consolidated or combined financial statements shall include all tax positions for each entity within the combined or consolidated group that is subject to income taxes or has income assigned to it from a pass-through entity.


For example, Entity A, a partnership with two partners, owns a 100% interest in Entity B and is required to issue consolidated financial statements. Entity B is a taxable entity that has unrecognized tax positions and a related liability for unrecognized tax benefits. Because entities within a consolidated or combined group should consider the tax positions of all entities within the group regardless of the reporting entity’s tax status, Entity A should include in its financial statements the assets, liabilities, income and expenses of both Entity A and Entity B, including those relating to the implementation of Topic 740 to Entity B. This is required even though Entity A is a pass-through entity.


Topic 740 does not provide an example where the parent entity is a taxable entity and the subsidiary is a pass-through entity. The guidance would suggest that the preparer of the consolidated financial statements would have to apply Topic 740 to the pass-through entity’s tax positions as well as those of the parent.



Topic 740 requires that when interest or penalties are to be paid on an underpayment of income taxes, an entity shall begin recognizing those expenses in the first period the expenses would begin accruing. The entity must disclose whether the interest and penalties are classified as income taxes or another expense category.



Nonpublic entities must disclose the following:


  The total amounts of interest and penalties recognized in the statement of operations and the total amounts of interest and penalties recognized in the statement of financial position


  For positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within 12 months of the reporting date:

a. The nature of the uncertainty

b. The nature of the event that could occur in the next 12 months that would cause the change

c. An estimate of the range of the reasonably possible change or a statement that the estimate cannot be made

  A description of tax years that remain subject to examination by major tax jurisdictions


Topic 740 exempts nonpublic entities from other disclosures in paragraph 740- 10-50-15A(a) through (b), as added by ASU 2009-06, concerning reconciliation of total amounts of unrecognized tax benefits at the beginning and end of a financial reporting period and the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate. Examples of disclosures can be found in the AICPA publication Accounting Trends & Techniques.



Topic 740 requires that its provisions shall be applied to all tax positions upon initial adoption. Only tax positions that meet the MLTN recognition threshold at the effective date may be recognized or continue to be recognized. The cumulative effect of application shall be reported as an adjustment to the opening balance of retained earnings (or other component of equity) for that fiscal year, presented separately. Thus for nonpublic entities with a calendar year-end of Dec. 31, 2009, the provisions of Topic 740 will need to be applied as of the beginning of the year.


Smaller private companies and tax-exempt not-for-profit organizations may need CPA practitioner assistance in implementation. The AICPA staff has provided the following guidance: “The provision of such services would not impair independence provided the client can make an informed judgment on the results of the member’s services and the other requirements of Interpretation No. 101-3 are met. In meeting the requirements of Interpretation No. 101-3, the member may assist the client in understanding why the tax positions do or do not meet the MLTN threshold and the basis for any unrecognized tax benefit so that the client can accept responsibility for the amounts reported and disclosed in the financial statements” (AICPA Professional Ethics, Frequently Asked Questions, Performance of Nonattest Services,



Many smaller nonpublic entities that file a federal income tax return and do business in only one state may believe they have no materially uncertain tax positions. However, regardless of how simple or how complex the entity’s tax situation is, all nonpublic entities must still consider all the provisions of Topic 740 and make the proper disclosures. This article provides only an overview of Topic 740. When preparing to implement Topic 740, entities should consult the entire standard.


Editor’s note: Co-author Judith H. O’Dell chairs the Private Company Financial Reporting Committee (PCFRC) that provided recommendations to FASB in adopting Topic 740 relating to accounting for uncertainty in income taxes. Co-author Paul H. Glotzer is a staff member of FASB and staff liaison to the PCFRC and the AICPA PCPS Technical Issues Committee. The views expressed in this article are those of the authors and not the positions of the Financial Accounting Standards Board. Positions of FASB are arrived at only after extensive due process and deliberations.





  Topic 740 of the FASB Accounting Standards Codification provides guidance for accounting for uncertainty in income taxes (formerly contained in FASB Interpretation no. 48). It is being implemented by private companies, including pass-through entities and tax-exempt not-for-profit organizations, in annual financial statements for periods beginning after Dec. 15, 2008.


  Entities must determine whether it is more likely than not that a tax position will be sustained upon examination and, if so, determine the amount of tax benefit to recognize in the financial statements.


  For pass-through entities and tax-exempt not-for-profit organizations, their taxable status is a tax position that must be evaluated. Even if it is determined that the entity’s pass-through or tax-exempt status would be sustained, other tax positions may still need to be considered. For S corporations, an example might be built-in gains tax or, for tax-exempt not-for-profit organizations, tax on unrelated business income.


  Accounting Standards Update 2009-06 modified the Codification to provide guidance for pass-through entities and tax-exempt not-for-profit organizations with respect to the definition of a tax position, attribution of income taxes to the entity or its owners, and the financial statements of a group of related entities. It also eliminated some disclosure requirements for these and other nonpublic entities with respect to unrecognized tax benefits.


Judith H. O’Dell ( chairs the Private Company Financial Reporting Committee . Paul H. Glotzer ( is a project manager at FASB.


To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at 919-402-4434 or .





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