What is Schedule UTP and who must file?
The IRS issued the final Form 1120 Schedule UTP on September 24, 2010. (http://www.irs.gov/pub/irs-pdf/f1120utp.pdf) Schedule UTP requires specific categories of corporate taxpayers to disclose positions taken in tax returns that are not certain of being sustained upon audit examination or in litigation proceedings.
Schedule UTP must be filed by public and private corporations required to file Form 1120, 1120F, 1120L or 1120PC for the calendar year 2010 or a fiscal year that begins in 2010 and ends in 2011 if the corporation
- has worldwide assets greater than or equal to $100 million,
- files audited financial statements and
- has recorded a reserve with respect to a tax position for U.S. federal income tax in the audited financial statements or did not record a reserve for a tax position because of an expectation to litigate the position.
Corporate taxpayers with assets less than $100 million will not be required to file Schedule UTP for 2010 and 2011, but will be required to report in future years based on a phase-in period. Corporations with assets equal to or in excess of $50 million will be required to file Schedule UTP in 2012 and 2013. Corporations with assets equal to or greater than $10 million will be required to file Schedule UTP in 2014 and beyond.
Other corporate and non-corporate entities are not totally off the hook either. The IRS is reviewing the timing of the filing requirement for corporations not specifically identified above (e.g. REITs and RICs), tax exempt entities, or pass-through entities (e.g. S Corporations and Partnerships).
What must be reported on Schedule UTP?
Tax positions taken on the U.S. federal income tax return for which the corporation or a related party recorded a reserve in the audited financial statements or positions where a reserve was not recorded because the corporation expects to settle or litigate the position must be reported. The reporting requirements apply only to tax positions that impact the U.S. federal tax liability and not to state and local or foreign tax liabilities.
Corporations are not required to report the amount of the tax adjustment that could apply if the IRS prevails on the position (i.e. amounts reserved for financial statement purposes). Instead, there must be a ranking of the reported uncertain tax positions on Schedule UTP based upon the magnitude of a potential adjustment. Tax positions for which no reserve is recorded based upon expectations to settle or litigate need not be ranked on the schedule. Major tax positions must be identified as such. A major tax position is defined as a reserve in excess of 10% of the total amount of reserves set aside for all federal tax positions for financial statement purposes.
In addition to listing and ranking the uncertain U.S. federal tax positions, taxpayers must provide a concise description of the position including relevant facts and other information that reasonably can be expected to allow the IRS to identify the tax position and the nature of the issue. Schedule UTP also requires a notification of whether the item is a temporary or permanent difference.
Only items reported in audited financial statements are required to be reported on Schedule UTP. Compiled and reviewed financial statements are excluded from this definition.
So far, only tax positions taken in 2010 and beyond should be reported, even if a historical reserve is on the audited financial statements. This is the way the Schedule UTP is designed for 2010. It is unclear whether this position will change in the future.
New “Frequently Asked Questions” (“FAQs”) guidance on Schedule UTP was issued by the IRS on March 23, 2011. The FAQs shed light on additional points related to the preparation of the form including: highly certain tax positions need not be disclosed, treatment of reversal of reserves in interim periods, the use of NOL or credit carryovers in a post-2009 return and when to include interest and penalties in determining the size of an uncertain tax position for ranking purposes. The FAQs on Schedule UTP can be accessed on the IRS website at http://www.irs.gov/businesses/article/0,,id=23758,00.html.
Planning Opportunities and Strategies
Obviously, the best strategy to avoid disclosure on Schedule UTP is to not have uncertain tax positions in the U.S. federal tax return. If there are uncertain tax positions, how can a taxpayer achieve certainty on those positions?
Some strategies taxpayers might consider include working with the IRS to achieve certainty through existing administrative procedures. Taxpayers may request a Private Letter Ruling (“PLR”), a Pre-Filing Agreement (“PFA”) or for transfer pricing matters an “Advance Pricing Agreement (“APA”) to obtain certainty about how a transaction will be viewed by the IRS. Favorable rulings or agreements received from the IRS will permit the taxpayer to exclude the related tax position from both Schedule UTP and the financial statement disclosures.
Taxpayers under the jurisdiction of the IRS’s Large Business and International Program may request that the IRS examine specific issues relating to returns before they are filed. If the issues are resolved prior to filing, the taxpayer and the IRS can have a pre-filing agreement. Unlike PLR’s, however, a PFA doesn’t determine the tax treatment of future transactions or events. It only applies to completed transactions or events which have not yet been included in a tax return.
Transfer pricing is expected to be a significant uncertain tax position for many taxpayers . An Advance Pricing Agreement is a vehicle to achieve certainty about transfer pricing methods. APA’s are long-term agreements (generally five years) in which the taxpayer and the IRS agree to a transfer pricing method.
APA’s are negotiated between the IRS and the taxpayer. The taxpayer submits a transfer pricing analysis and proposed method to the IRS APA Office. A user fee is required. The IRS examines the information and negotiates with the taxpayer to arrive at an APA. The taxpayer also may request a “bilateral” APA, which is agreed to by both the IRS and the tax authorities of another country, and which can provide additional certainty to the transfer pricing position for the taxpayer.
Another strategy that exists for taxpayers relates to accounting methods. If a taxpayer has a reserve for an improper method of accounting, the taxpayer should consider filing a Form 3115, Application for Change in Accounting Method. If the taxpayer changes from an improper method to a proper method of accounting, favorable treatment can be obtained in picking up the related detrimental accounting change adjustment over a period of four years. Further, the IRS will not make an examination adjustment relating to the taxpayer’s use of the improper method for any prior year.
Independent auditors issuing reports on financial statements are attentive to the exposure to IRS audit examinations resulting from Schedule UTP. This poses audit risk for the independent auditor to ensure those positions are properly accounted for in the financial statements. Management must be focused on solidifying its position with regard to uncertain tax positions by the time the financial statements, not just the tax returns, are filed.
Schedule UTP will affect large corporations starting this year and increasingly more taxpayers in the near future. Since uncertain tax positions will be identified and ranked based upon the magnitude of booked reserves, IRS agents will spend less time identifying and more time analyzing those positions. Independent auditors issuing reports on financial statements will continue to be vigilant that tax reserves are properly recorded. Management of entities required to report on Schedule UTP should not wait to adopt strategies to eliminate disclosures of uncertain tax positions. While some of the possible strategies may take time to achieve, they are likely to be worthwhile efforts to mitigate the IRS audit examination process.