FEDERAL Accounting Board Seeks to Clarify Reporting of Uncertain Tax Positions

Determining tax liability has long involved as much art as science. Accounting for tax liabilities adds a further layer of judgment–or some would say confusion–to the process. As a result, experts say there has been a wide divergence in practice as to how various entities have been accounting for income taxes in situations where the tax position was uncertain. The result, say critics, is a degree of opacity when comparing tax accounting of companies. In an attempt to bring some clarity and uniformity to how companies were accounting for uncertain tax position, in 2005, the Financial Accounting Standards Board waded into the matter and published FIN 48, an Exposure Draft of a proposed Interpretation of FASB Statement 109, Accounting for Uncertain Tax Positions.

However, the original draft appeared to further confuse things. As drafted, the original proposal required filers to supply the “probable” tax liability or benefit in their financial statements. As originally proposed, a company would have been required to recognize, in its financial statements, the best estimate of the effect of a tax position only if that position had the probability of being sustained on an audit based solely on the technical merits of the position. To many, this “probable” standard for recognition had the potential to burden corporate tax departments even more than the infamous Section 404 of the federal Sarbanes-Oxley Act relating to the documentation of internal controls. The Tax Executives Institute, for instance, commented that the “probable” standard would be unduly complex, difficult to implement in practice and cause widespread overstatement of tax liabilities.

Clarified Definitions Help Determine Tax Positions
Fortunately, FASB listened and replaced the “probable” standard with a “more likely than not” standard for tax benefit recognition. In evaluating whether the more-likely-than-not recognition threshold has been met, the proposed Interpretation requires the presumption that the tax position will be evaluated during an audit by taxing authorities. For example, according to the Interpretation, this standard is met when a deduction “will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position.” The more-likely-than-not standard is met when the likelihood that the deduction will be sustained upon examination is more than 50%.

Here’s an example of how this might work in practice for transfer pricing, an area notorious for ambiguity and disagreement: If the pricing analysis is appropriately prepared with all facts objectively verifiable, all assumptions are reasonable and supportable, and the choice of the amounts to be recorded are also reasonable and supportable, it would support management’s best estimate for use in measuring the tax effects of the inter-company transactions in the financial statements of the consolidated entity and each of the subsidiaries.

Individual tax positions that fail to meet the more-likely-than-not recognition threshold will generally result in either a reduction in the deferred tax asset (alternately, an increase in a deferred tax liability) or an increase in a liability for income taxes payable (alternately, a reduction of an income tax refund receivable).

With Consistency Comes Clarity
The Interpretation is effective for fiscal years beginning after December 15, 2006.

The FASB intends for this Interpretation to increase relevance and comparability in financial reporting of income taxes, since all tax positions accounted for in accordance with Statement 109 will be evaluated for recognition, derecognition and measurement consistently. In addition, the disclosure provisions of this Interpretation will give investors, suppliers and financial institutions more information about the uncertainty in income tax assets and liabilities.

Time will tell whether FASB FIN 48 has cleared up the confusion or added to it.

For more information, please contact Peter Orfanakos at porfanakos@gellerco.com.

STATE & LOCAL Municipal Bonds’ Tax-Exempt Status Faces Court Challenge

State and local government bonds have long been a favorite vehicle for investors seeking to minimize their tax burden, as the bonds’ interest payments are exempt from federal income taxes. (However, capital gains on the sale of such bonds, which are usually lumped together under the term municipals, are taxable at the federal level and in some states.) States and municipalities benefit from the special status of these bonds because the tax exemption enables them to borrow at a lower interest rate than they would otherwise pay.

In states that levy income taxes, interest on municipal bonds is typically exempt from state taxes, also, as long as the issuing entity is in the same state as the taxpayer. Buy a municipal bond from a state other than where you reside, however, and you could owe state income taxes on the interest income, depending on the state. This arrangement has kept the markets for municipal bonds focused around their home markets. As a result, mutual funds have created separate municipal bond funds for each state, and investors rarely buy bonds issued out-of-state.

The System Being Challenged
Now this system is being challenged. A Kentucky couple contends that the differing tax treatment of in-state versus out-of-state municipal bond interest payments is discriminatory and violates the equal protection clause of the U.S. Constitution. The case has captured national attention, and the U.S. Supreme Court has agreed to hear arguments on the matter.

The outcome of this case could have major repercussions on the estimated 4.5 million investors with money in the estimated $2.4 trillion of outstanding municipal bonds, as well as on the future cost of borrowing for states and cities. If Kentucky loses, the state will have a tough choice: impose the income tax on Kentucky bonds or extend the tax exemption to out-of-state bonds. Moreover, if Kentucky loses, there are other similarly discriminatory provisions in state tax laws, such as investment tax credits and other incentives, which could be in jeopardy. Whatever happens, expect other states to follow suit.

If you’re an investor, all you can do is hold on to your bonds and wait for a decision. Don’t hold your breath, though. Oral arguments are not expected until fall, and a decision probably won’t be forthcoming until sometime next year. With that in mind, taxpayers with significant amounts of municipal bond interest ought to speak with their tax advisers about the possibility of filing protective claims.

For more information, please contact Carolyn Makuen at cmakuen@gellerco.com.

INDIVIDUAL Kiddie Tax Begins to Take a Bigger Bite

The federal “kiddie tax” is no longer child’s play. Recent changes in federal income tax law are bumping income derived from the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA)–custodial accounts set up to allow adults to save on behalf of minors–into higher tax brackets and forcing families to rethink how they set aside savings for their children’s future.

Originally, the kiddie tax was adopted by Congress to prevent parents in a high tax bracket from shifting investment income to their children, who would pay at a lower tax rate. To prevent income-shifting, the kiddie tax imposed the parent’s marginal tax rate on children under the age of 14 when their income exceeded a certain level. Last year, the kiddie tax was widened to include individuals under the age of 18, and recently Congress went even further. Starting in 2008, the new law applies to children that are 18 years old (19-23 years old if a full-time student).

How it Works
Here’s how the kiddie tax works: The standard deduction enables the child to receive the first $850 of investment income tax-free. The next $850 is taxed at the child’s rate, which can be as low as 10% for certain dividends, interest and short-term capital gains (5% for long-term capital gains and qualified dividends). For the current tax year, 2007, the kiddie tax, in other words, the parent’s marginal tax rate, is applied only to investment income in a child’s name (under the age of 18) in excess of an inflation adjusted threshold of $1,700. For tax years beginning in 2008, children between the ages of 18 and 23, who are affected by the new law, can escape the kiddie tax if they earn more than half of their total financial support from a job.

The expanded kiddie tax has put UTMA and UGMA accounts at a severe disadvantage to 529 College Savings Plans. Depending on circumstances, income from a UTMA or UGMA account can be taxed at a rate of 35%, whereas a withdrawal from a 529 Plan is tax-free, as long as the money goes toward higher education expenses at an accredited institution. UTMA and UGMA accounts leave spending at the discretion of the guardian until the child reaches the age of majority, 18 or 21 depending on the state. At that point, the child has complete control over the account.

The changes to the kiddie tax have created one more reason for parents to use 529 Plans as the preferred vehicle for college-saving. Not only are withdrawals to cover college expenses tax-free, but investments in the accounts grow tax-free as well. Parents may also buy Series EE bonds for the child and have the child elect to defer tax on the interest as it accrues. The parent may also look into placing the UGMA and UTMA funds in tax exempt bonds. If there is a family business, the child can be employed in the family business or in the performance of chores supporting the payment of earned income. The earned income can be sheltered by the standard deduction amount of no greater than $5,350.

What if You’re Already Invested in a UTMA or UGMA?
What are parents who established UGMAs or UTMAs years ago to do in light of the changes? Converting UGMA or UTMA accounts to 529 Plans could be difficult, and advisors typically aren’t recommending it. Instead, parents with children who do not fall under the kiddie tax in 2007, but will in 2008 could start drawing down on those UGMA and UTMA accounts and take the capital gains this year while they are taxable at the child’s rate.

Families weighing the alternatives should consult with their tax advisors to determine the course of action best suited to their individual needs and circumstances.

For more information, please contact Sherry Reisch at sreisch@gellerco.com.