September 23, 2011

Uncertain Tax Positions for Flow Through Entities – Impact of Non-Income Based State Taxes

By Robert H. Smith, Senior Tax Manager

Uncertain Tax Positions for Flow Through Entities – Impact of Non-Income Based State Taxes

Financial Accounting Standards Codification (ASC) Topic 740, formerly known as FIN 48, relating to Uncertain Tax Positions, requires an evaluation and disclosure of the risks associated with uncertain positions.ASC 70 was effective for public companies for fiscal years beginning after December 15, 2006 and for non-public companies – including non-profits, real estate investment trusts, registered investment companies and flow through entities with fiscal years ending on or after December 15, 2008.This article addresses the concerns of the whether state taxes paid for flow through entities are deemed “income taxes” and therefore, require analysis for ASC 740 purposes.

Flow through entities do not normally pay income taxes. However, many states have adopted gross receipts or net-worth tax structures in lieu of a more traditional income tax as a means of expanding their tax bases under the guise of relative ease of administration and lack of complexity in their calculation.

Since ASC 740 only applies to income tax, the question arises as to whether state taxes paid by flow through entities would be deemed income tax subject to analysis under ASC 740.Part of the determination of treatment would include an analysis of whether the tax assessed is subject to apportionment, state constitutional standards, income tax nexus standards, and treatment of the tax on the state return as either deductible as a fee or creditable as a tax paid to other states. Several states including TX, MI, OH and OK have enacted tax systems that have characteristics of both sales and income taxes.

ASC 740 defines “income tax” as domestic or foreign federal (national), state, and local (including franchise) taxes based on income. ASC 740 does not apply to franchise tax to the extent the tax is based on capital and there is no additional tax based on income.If there is additional tax based on income, the excess is considered income tax that would be subject to ASC 740.Therefore, most state tax assessments including some franchise taxes based on earned surplus or income taxes would qualify as “income taxes” and come under the umbrella of ASC 740.The states where this is especially true include: CA, DC, IL, KY, MA, MI, NH, TN, TX and WI.

In summary, it is clear that the categorization of state payments assessed for flow-through entities as either income tax or as gross receipts tax depends on the purpose for which the question is asked.For purposes of ASC 740, flow-through entities may need to perform additional analysis to determine if any state tax payments made qualify as “income tax” and are therefore applicable for ASC 740 purposes.