Uncertain tax positions for flowthrough entities: what is an income tax?

• Author: Wright, Kathleen K.

PRIVATELY HELD BUSINESS ENTITIES WERE swept up into the complexity of accounting for uncertainty in income taxes in 2009. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 740, relating to accounting for uncertainty in income taxes, requires evaluation and disclosure of the risk associated with uncertain tax positions taken or expected to be taken in a tax return. (1) The portion of ASC 740 formerly known as FIN 48 was effective for fiscal years beginning after December 15, 2006, for publicly traded companies and was made applicable to all business enterprises including not-for-profit organizations, passthrough entities, real estate investment trusts, and registered investment companies for years beginning after December 15, 2008.

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This column examines the unique state tax issues that arise under ASC 740 for privately held business entities that are organized as flowthrough entities. For federal purposes, only a small percentage of flowthrough entities pay income taxes, with the most notable exception being certain S corporations. If the scope of ASC 740 did not extend beyond federal law, the number of flowthrough entities subject to the analysis would be minimal. For state purposes, a significantly larger population of flowthrough entities will be subject to this analysis as states move toward assessing various types of gross receipts taxes on flowthrough entities. States have adopted gross receipts tax structures in lieu of the more traditional income tax as a means of expanding their tax base under the guise of relative ease of administration and the lack of complexity in their calculation. This column discusses assessments made by various states to determine whether they are income taxes and subject to the ASC 740 analysis.

Assessment of an Income Tax

ASC 740 applies only to business entities subject to income taxes. The question of whether a wide variety of state taxes fall under the rubric "income taxes" has raised vexing questions, including whether the assessment is subject to apportionment, state constitutional standards, income tax nexus standards (such as P.L. 86-272), treatment on the state return (i.e., deductible as a fee or creditable as a tax paid to other states), and applicability of ASC 740.

Several states (most notably Texas, Michigan, Ohio, and recently Oklahoma) have enacted tax systems that have characteristics of both sales and income taxes. These states (and others) have issued their own opinions on whether these assessments are income taxes or are more in the nature of fees. These determinations generally deal with whether the levy is a sales and use tax or an income tax and, if an income tax, whether it is deductible on the state return. The results are far from consistent.

ASC 740-10-20 defines "income tax" as domestic and foreign federal (national), state, and local (including franchise) taxes based on income. While ASC 740 does not include a definition of "income subject to tax," it does include a definition of certain types of assessments to which ASC 740 does not apply. It does not apply to a franchise tax to the extent it is based on capital and there is no additional tax based on income. If there is an additional tax based on income, that excess is considered an income tax and is subject to ASC 740. (2)

Example: In August 1991, State A amended its franchise tax statute, effective January 1,1992, to include a tax on income apportioned to the state based on the federal tax return. The amount of franchise tax on each corporation was set at the greater of 0.25% of the corporation's net taxable capital or 4.5% of the corporation's net taxable earned surplus. Net taxable earned surplus was defined in the state statute by reference to the corporation's federal taxable income. (3) ASC 740-10-55-141 concludes that the total computed tax in this case "is an income tax only to the extent that the tax exceeds the capital-based tax in a given year." Only that portion of the tax is subject to the analysis required under ASC 740.

Under this very broad definition, most state assessments, including some franchise taxes based on earned surplus or income taxes, qualify as income tax payments under the umbrella of ASC 740. Assessing a tax on the earned surplus implies that an income tax is assessed if the base of the tax is reduced by at least some deductions. This is the approach taken by most practitioners with respect to the applicability of ASC 740, although this is not the approach taken by the states when they analyze taxes for purposes of determining deductibility.

An increasing number of state assessments are based on gross receipts or gross income and exhibit characteristics of both fees and income taxes. Various state and local taxes may have income tax-like elements that can potentially belie their nomenclature as something other than an income tax. When compared with net income taxes, the most significant difference is that deductions are not permitted. Several of these taxes are discussed here to the extent that they have spawned controversy.

Texas: The Texas Margin Tax

Effective January 1, 2008, Texas changed its former franchise tax to a margin tax. The margin tax is described as a tax based on gross receipts with certain allowable deductions. (4) The taxable margin is computed based on the lesser of:

* 70% of the taxable entity's total revenue from its entire business; or

* The taxable entity's total revenue from its entire business less--at the election of the taxable entity--either cost of goods sold (COGS)...